Following a turbulent market period fueled by social-media driven trading in so-called “meme” stocks, FINRA has issued a detailed regulatory notice, taking direct aim at certain broker-dealer actions.  Specifically, in Regulatory Notice 21-12 (the “Notice”), FINRA reminds firms that (a) they should have capacity to handle periodic spikes in message traffic and trading activity and (b) unfair disclosures in customer account agreements will not relieve a firm of its best execution obligations for handling customer orders.  The Notice specifically calls out customer agreements that allow the firm “in its sole discretion, [to] prohibit or restrict trading without notice.”  This, along with the statements on regulators’ expectations for systems capacity and the “need [for member firms] to have effective liquidity management practices,” suggests a clear preference against restricting customer trading.  FINRA appears to believe that firms should not manage clearing corporation deposit requirements, liquidity risk, or systems capacity demands by restricting trading, but rather should maintain systems and controls to meet those requirements and demands without restricting trading.  

Best Execution

A significant portion of the Notice reiterates guidance from NASD Notices to Member 99-11 and 99-12 that broker-dealers’ procedures for handling customer orders “must be fair, consistent, and reasonable during volatile market conditions and otherwise.”  Firms must be particularly mindful of their handling of marketable orders during periods of volatility and extreme conditions.  Under FINRA Rule 5310, broker-dealers must execute market and marketable limit orders promptly, and a delay in executing such orders due to an influx of orders or market volatility is not consistent with a broker-dealer’s best execution obligations.

The Notice recognizes that a firm might need to change order-handling practices during extreme or volatile market conditions and even restrict the entry or acceptance of customer orders.  The Notice cautions, however, that firms “must implement such changes on fair, consistent and reasonable terms.”  This is coupled with a direct statement expressing FINRA’s desire that firms endeavor to permit customer trading rather than restrict it.  Specifically, FINRA states that “firms should consider establishing and implementing procedures that are designed to preserve the continued execution of customer orders . . . while also recognizing and limiting the exposure of the firm to extraordinary market risk.”  FINRA also warns that changes to order-entry procedures should be limited, well-documented, and implemented only when warranted by market conditions.  FINRA will not look favorably upon frequent changes to order-handling practices, particularly those occasioned by inadequate systems capacity.  Accordingly, if a firm does need to modify its order-handling practices under extreme market conditions, it should consider the effect of that action.  It should consider which clients might be affected and seek to implement its change in the most fair, consistent, and reasonable manner.  For example, if the concern is reducing risk at clearing corporations, the firm’s order-handling change should be designed to address only that risk, such as by limiting new positions or positions that increase risk, rather than trading activity that reduces or closes risk positions.  If a change is driven by capacity concerns, the change should affect all customers fairly, rather than maintain access for selected categories of clients.  As discussed below, clear and timely disclosure of the nature of the change and the reasoned basis for it are key.

Meaningful Customer Disclosures

The Notice primarily reiterates guidance first published in 1999, during the volume and volatility of the “dot.com” era and the advent of online trading.  The guidance remains relevant today, perhaps even more so, with high-speed internet, smartphones, and trading apps creating additional and faster retail order-entry channels.  The Notice reminds that if firms implement different order-handling procedures in extreme market conditions, they should advise customers in advance of those different procedures and the circumstances that may trigger them.  Certain other disclosures help to advise and educate retail customers about the risks of volatile markets.  For example, customers should be informed of the difference between market orders and limit orders, particularly in volatile markets.  Market orders must be executed promptly, but the “market” can change drastically in volatile markets and the execution price can be far different from what a customer anticipated.  Similarly, stop orders without a limit price become market orders when triggered and brief price swings during volatile markets can trigger stop orders unexpectedly.  Customers should be reminded of these and similar risks and possible ways to mitigate them, including by using limit orders and stop limit orders.  Firms with a broad retail customer base regularly make these disclosures, but the Notice provides a helpful reminder of the need to educate customers, particularly those that are new to trading and now have easier access to the markets.  Again, when this guidance was first presented in 1999, online trading was relatively new.  Since then, retail customers have easier access to the markets and some methods of order entry have less screen space for disclosures.  This makes it all the more important to make meaningful disclosures in advance to customers.

Liquidity Management

One of the more direct warnings in the Notice is FINRA’s reminder that firms must have effective liquidity management programs.  The relevance of this warning is obvious, given the recent effect that “meme” stocks and other concentrated and volatile trading have had on broker-dealers’ (or their clearing firms’) clearing corporation deposit requirements.  FINRA warns that “[m]ember firms facing the potential for rapid changes and concentration in order volume should expect commensurate changes in [clearing corporation] requirements.  It is important for a member firm to model potential [clearing corporation] requirement spikes, and to assess whether it has adequate funding available to meet those spikes.”  Removing any doubt that recent meme stock activity informs the guidance, FINRA highlights “the potential for concentrations of customer activity and trading in specific highly volatile, low-priced or illiquid securities, which may increase” such requirements.

Notably, FINRA issued guidance in 2010 and 2015 on liquidity management practices.  That guidance did not put firms directly on notice of the need to manage liquidity risks from changes in clearing corporation deposits, but the 2015 guidance indirectly and obliquely referenced such risk.  That indirect reference now takes on greater importance following the recent meme stock volatility and the interest of the press, Congress, and other regulators following that volatility.  In the 2015 guidance, FINRA described the testing it had recently performed of certain firms’ liquidity-risk management, including the “stresses” that it asked those firms to apply to their businesses in connection with that testing.  For one of the five stresses, FINRA requested that the reviewed firms “assume a doubling of clearing deposits, whether client or firm related, on Day 1.”  (FINRA Regulatory Notice 15-33 at 4.)  Although the recent meme trading may have resulted in clearing deposit increases far beyond mere doubling, firms are now clearly on notice that FINRA expects appropriate modeling and stress testing of clearing corporation deposits and an evaluation of the “adequacy of capital and availability of contingent funding sources to provide customers ongoing access to the markets.”

Conclusion

Given the significant interest of both Congress and the press in retail investors’ access to the markets during volatile trading in meme stocks and the resulting pressure on regulators to oversee market participants’ activities in this area, it should come as no surprise that FINRA would take a direct and pointed view on core issues relating to best execution, market integrity, and investor protection.  The Notice suggests that, going forward, FINRA will be far less tolerant of a broker-dealer failing to adequately manage its liquidity or anticipate clearing deposit requirements, regardless of market conditions.  To the contrary, FINRA appears to require firms to anticipate significant increases in customer orders, not only to maintain sufficient systems capacity, but also to model for clearing corporation requirements and other liquidity needs.  Broker-dealers should take the opportunity to review their order-handling practices under volatile market conditions, the disclosures they provide to clients, and the models they use to stress test clearing corporation requirements and other liquidity management practices.  Broker-dealers that may require additional capital to meet clearing deposit or other requirements should consider lining up contingent sources of capital rather than defaulting to restrict trading