What FINRA Will Look for in U.S. Broker-Dealer Exams
Broker-dealers should ensure they have top-notch controls for how they supervise staff, outsourcing agents, the pricing of hard-to-value securities, pre-trade risk monitors and margin lending practices if they want to pass muster with the Financial Industry Regulatory Authority.
The five functions appeared among a list of 28 areas FINRA will be targeting during those dreaded broker-dealer exams. The areas were outlined in a 16 page letter FINRA just released, which can be found through http://www.finra.org/web/groups/industry/@ip/@reg/@guide/documents/industry/p125492.pdf.
Here is a synopsis of just five of the categories brokers need to shore up:
1-Supervision: Brokers must establish and enforce adequate supervisory systems and internal controls, not only to ensure compliance with applicable rules and regulations, but also to mitigate business risk. Brokers that sell higher risk products or services need to have "corresponding supervisory policies and procedures that are reasonably designed to ensure adequate due diligence and higher risk products are limited and properly marketed to retail investors." Firms that have customer-facing executives in remote locations must maintain "adequatge supervisory structures to mitigate enhanced business conduct rules."
2-Outsourcing agreements: Brokers trying to cut expenses and focus on their core businesses are often using third parties to carry out some of their functions. However, as FINRA warns, doing so doesn't absolve them from conducting "ongoing due diligence" to ensure the agents are capable of performing those functions. Among the most common outsourced functions, say operations executives, are post-trade reconciliation, reference data management; corporate actions management and customer onboarding.
3-Procedures for pricing of illiquid or hard-to-value securities: FINRA says firms must have written processes in place to obtain reliable valuations for illiquid and hard-to-price securities, such as private label mortgage-backed securities and various structured products. Bottom line: brokers can't rely solely on their trading desks, which have an obvious vested interest in whatever figures they cite. "Examiners will continue to review a firm's processes and procedures for reviewing and verifying the valuation of these securities, including whether the valuations were consistent, irrespective of whether a security is held in a firm's inventory as collateral for a financing transaction or in a customer account. Examiners will also evaluate the robustness and independence of a firm's valuation groups and process for escalating pricing differences to senior management."
4-Compliance with market access rule: FINRA says its staff will review a firm's written supervisory procedures and risk controls to validate they meet the requirements of the Securities and Exchange Commission's 15c3-5, which became fully effective in November 2011. That rule mandates broker-dealers have risk management controls and supervisory procedures in place to manage the financial, regulatory and other risks involved with allowing a client to directly access a trading venue using the broker's identification code. "Examination staff will review written supervisory procedures, including controls to prevent entry of orders that exceed appropriate pre-trade capital or credit thresholds, risk management controls to prevent erroneous and duplicative orders and controls to prevent the entry of orders that fail to comply with the SEC, FiNRA or exchange rules," says FINRA.
5-Margin lending practices: FINRA warns that firms must determine whether the collateral supporting receivables -- aka margin-- is readily marketable, appropriately valued, and readily available to finance the credit extended to customers. "We have seen instances in the past where companies have extended credit through margin lending or reverse repo transactions on complex structured products that were difficult to value," says FINRA. "In these situations,must adequately assess the sufficiency of such collateral, the valuation and liquidity of this collateral as well as the concentration of collateral in a specific security or class of securities in a single customer account and across all customer accounts." FINRA recommends that firms have a "governance practice" in place to determine whether or not they should extend credit against less liquid or concentrated asset classes.
Written by Chris Kentouris, Editor-in-chief. (Chris can be contacted through Chris.Kentouris@hotmail.com).
