On January 22, 2019, the Financial Industry Regulatory Authority (“FINRA”) published its 2019 Risk Monitoring and Examination Priorities Letter (“2019 Priorities Letter”). FINRA annually publishes its Priorities Letter to highlight the areas on which it intends to focus for the upcoming year. While the majority of 2019’s focus areas are the same as last year’s (sales practice risks, senior investors, cybersecurity, fraud, and market manipulation), FINRA is changing its focus somewhat to include online distribution platforms; compliance with FinCEN’s Customer Due Diligence rule; and compliance with mark-up or mark-down disclosure obligations on fixed income transactions with customers.
Online Distribution Platforms
FINRA emphasized its concern that certain member firms may be selling or recommending securities when involved with online distribution platforms despite affirmations to the contrary. Thus, FINRA will be paying close attention to reasonable basis and specific customer suitability analyses, the completeness and accuracy of communications with the public, and compliance with anti-money laundering (AML) requirements, as well as requirements related to sales to non-accredited investors and disclosures of compensation arrangements amongst firms and issuers.
Fixed Income Mark-Up Disclosure
FINRA will have its eye on compliance with mark-up and mark-down disclosure obligations on fixed income transactions consistent with amendments to FINRA Rule 2232 and MSRB Rule G-15, which became effective in May 2018.
FINRA intends to liaise with member firms to understand how they are using new regulatory technology in order to abide by their compliance requirements, as well as how they are addressing associated risks, including issues of supervision and governance, third-party vendor management, safeguarding of customer data, and cybersecurity.
Sales Practice Risks
Suitability will remain a top priority once again for FINRA this year. Specific areas of focus include quantitative suitability determinations, over-concentrations in illiquid securities, and recommendations to purchase share classes that are not in line with a customer’s investment time horizon or to be held for a period of time inconsistent with the security’s performance characteristics. FINRA will also be looking at suitability of complex products including leveraged and inverse exchange-traded funds (“ETFs”), floating-rate loan ETFs, and certain mutual fund investments.
FINRA will continue to focus its attention on protecting senior investors, including protections against fraud, sales practice abuses, and financial exploitation. FINRA will monitor firms’ application of the new FINRA rules regarding the naming of trusted contacts and the placing of temporary holds on disbursements. FINRA Rules 2165 and 4512. In addition, FINRA will oversee accounts where registered representatives serve in a fiduciary capacity with non-familial customer accounts and related supervisory systems.
Operational Risks Associated with Digital Assets
FINRA will work together with the Securities and Exchange Commission (“SEC”) to supervise digital asset businesses. In particular, FINRA will be focusing on whether a particular digital asset is a security and if firms have implemented proper controls and supervision over compliance with rules related to marketing, sales, execution control, clearance, recordkeeping, and valuation in addition to AML/Bank Secrecy Act rules.
FINRA will review firms’ compliance with FinCEN’s new Customer Due Diligence Rule that became effective in May 2018. The CDD rule requires that firms ascertain the identity of beneficial owners of legal entity customers, understand the nature and purpose of customer accounts, conduct ongoing monitoring of customer accounts to identify and report suspicious transactions and, on a risk basis, update customer information. Reviews will focus on the data integrity of suspicious activity monitoring systems as well as decisions associated with changes to those systems.
FINRA will focus on ensuring that firms undertake reasonable due diligence measures to ensure that that their customer order flow remains directed to the best market given the size and types of transactions, the terms and conditions of orders and other factors. Accordingly, FINRA will review firms’ best execution decision-making and in particular, occasions where firms have routed all or substantially all customer orders to a small number of wholesale market makers, or an affiliated broker-dealer or an alternative trading system in which the firm had a financial interest.
FINRA will continue its focus on monitoring manipulative trading in correlated exchange traded products (“ETPs”), including those that track broad market indices. FINRA plans to use pattern recognition and expand the use of machine learning to react to changes in the ETP market.
FINRA will review firms’ credit risk policies, including exposures created by transactions a firm’s customers and correspondents execute “away” from the firm, absent the firm’s participation until after execution. This may be incurred under clearing, prime brokerage, give-up, or sponsored access arrangements. FINRA will also examine credit risks linked with customer margin accounts that contain illiquid, volatile, or concentrated securities positions, products, or strategies.
Funding and Liquidity
Other focal points not covered by the 2019 Priorities Letter but emphasized as areas of concern in 2019 include risks related to the hiring and supervision of “associated persons with problematic regulatory history” and the adequacy of firms’ cybersecurity programs.
Although FINRA’s 2019 Priorities are largely identical to its priorities in years prior, it is most notable that FINRA will actively review the role played by broker-dealers involved in online distribution platforms for the first time. Therefore, it is imperative that broker-dealers involved with such platforms, as well as non-broker-dealer platform sponsors, cautiously assess how they are addressing the risks addressed by FINRA.
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