Abstract Tech

Regulatory Roundup: Expectations of PTFs

Tony Sio
Tony Sio Head of Regulatory Strategy and Innovation

Commentary & Analysis

In this month’s analysis, we’ll discuss principal trading firms (PTFs), also often referred to as proprietary trading firms. PTFs are an interesting segment of the market, and in the past month, the U.K. Financial Conduct Authority (FCA) outlined its views on the most important risks coming from PTFs and its supervisory focus. Meanwhile, in Europe, a recent survey of PTFs by Acuiti found a large portion of firms are considering leaving the region due to increased regulatory costs. PTFs are also in the spotlight in the U.S. On Aug. 23, the U.S. Securities and Exchange Commission (SEC) voted to change Rule 15b9-1 to expand the remit of national securities associations such as the Financial Industry Regulatory Authority (FINRA) to cover previously exempt proprietary trading firms.    

Definitions vary from country to country; however, for this discussion, PTFs will refer to those firms whose main revenue stream comes from trading in their own account. Their activity can often include things like high-frequency trading, algo trading, and market making. PTFs play an important role in the financial ecosystem, for example, by providing liquidity in specific securities.

Previously, a large number of U.S. PTFs had been exempt from registering with a national securities association (in practice, this would be FINRA) if they were members of a national securities exchange and carried no customer accounts. There was an additional requirement that they not trade on a different exchange; however, this did not count if it was through a registered broker-dealer, which many firms did. This meant that, in practice, many PTFs (that were exchange members) transacted across a variety of different exchanges without needing FINRA registration. The amendment greatly limits the types of activity a firm can engage in outside of the exchange it is a member of and still retains the exemption.

As part of the rationale for the changes, the SEC flagged that trading has become much more complex across multiple venues and that “proprietary trading broker-dealer firms have emerged that engage in significant, computer-based or algorithmic, securities trading activity … often at lightning speeds”.

This portion of the SEC’s rationale for additional focus dovetails with the first item on the FCA’s recent letter to PTFs, while U.S. firms may be able to draw some insights from the others. The FCA outlined five supervisory focus areas:

  1. Algorithmic trading controls
  2. Financial resilience
  3. Avoiding market disruption arising from commodity market volatility
  4. Operational resilience
  5. Brexit impacts

Looking specifically at algorithmic trading, they noted inherent risks and, therefore, the need for specific controls and oversight to address them. They mention that the PTFs with a relatively large trading footprint and those that use algorithmic trading strategies pose a heightened risk of harm.

Algorithmic trading controls have been a key risk since the start of their initial usage. A very early case gives a good example of others that follow. Infinium Capital Management, a PTF based in Chicago, was fined in 2011 after an algo it used caused turmoil on the CME. It was later revealed that the algo had only been backtested for one or two hours before being deployed onto the live market, significantly less than its internal standards. These events still occur; however, firms have learned that there is an expectation to perform rigorous testing, monitor firm activity, and react much more quickly to errors. Additionally, we have seen regulators and exchanges implement circuit breakers, improved monitoring, and other market controls introduced globally. Nonetheless, the technology continues to advance, and the FCA flagged artificial intelligence as an area that a firm’s controls needed to keep pace with.

The use of algorithmic trading as a potential tool of manipulation is also a regulatory concern. One landmark case involved Panther Energy Trading in 2013, where the firm used algorithmic trading tools to engage in spoofing of commodity futures on ICE and CME. Algorithmic or not, spoofing involving PTFs is still a concern, with a spoofing case on the Israeli TASE serving as a recent example.

PTFs and the environment they operate in have evolved considerably in past years. They have always been at the forefront of technology adoption and are certainly abreast of the latest rapid changes in technologies such as generative AI or asset classes such as crypto. It will be interesting to follow how the industry adapts to the changing regulations and the approach they will take.

Regulatory Updates

23 August: Singapore authorities requested documents from at least 10 financial institutions in a S$10 billion money laundering investigation. Ten suspects were detained after an investigation that led to the seizure of luxury homes, cars, designer goods, and other assets. Two of the banks charged include Citigroup’s Singapore subsidiary and Malaysia’s CIMB.

23 August: The SEC approved amendments to rules that narrow the exemption from the Securities Exchange Act of 1934, requiring registered brokers and dealers to become members of national securities associations. There have been instances of regulatory gaps due to outdated exemptions, leading to amendments aimed at enhancing oversight, specifically in cross-market and off-exchange oversight.

17 August: The FCA published a note with its expectations for U.K. crypto-asset businesses complying with the Travel Rule. Beginning Sept. 1, 2023, crypto-asset businesses in the U.K. will be required to collect, verify, and share information about crypto-asset transfers – known as the ‘Travel Rule’. The Travel Rule is designed to bring greater transparency to crypto-asset transfers, making it harder for criminals to use crypto-assets for illicit activities.

15 August: The Monetary Authority of Singapore (MAS) finalized the Stablecoin Regulatory Framework. Stablecoin issuers will have to meet specific requirements on reserve assets, capital, liquid assets, and disclosure to become licensed in Singapore.

14 August: The Federal Reserve released two supervisory letters to address the five issues listed in the November 2021 statement on the federal banking agencies’ crypto-asset policy sprint. One of the letters introduces a program to supervise novel activities, and one provides details on the process for state member banks to engage in certain stablecoin activities.

11 August: The China Securities Regulatory Commission (CSRC) and Hong Kong’s Securities and Futures Commission (SFC) reached a consensus on introducing block trading in the link between Hong Kong and mainland China. Both exchanges will release operational details and the launch date in due course.

10 August: The Canadian Securities Administrators (CSA) launched a review of ETFs. Throughout 2023, the CSA will assess whether the current ETF regulations are appropriate, and it will conduct an analysis of the market to determine whether consultations and/or regulatory changes are necessary to improve the current regulatory framework applicable to ETFs.

7 August: The Royal United Service Institute (RUSI) published the "Institutional Virtual Asset Service Providers and Virtual Assets Risk Assessment Guide," designed to provide a standardized approach to assessing financial crime risk within the cryptocurrency industry. The guide documents observed and emerging risks to allow institutions to identify high-risk activities and determine strategies to tackle such risks.

7 August: The Securities and Futures Commission (SFC) released a statement that warns unlicensed VATPs (Virtual Assets Trading Platforms) of the legal and regulatory consequences of improper practices and reminds investors to be wary of the risks of trading virtual assets on unregulated VATPs.

31 July: The SEC issued risk alerts citing flaws in Wall Street brokers’ efforts to combat money laundering. In 2016, the U.S. Treasury implemented the Customer Due Diligence (CDD) Rule, mandating financial institutions to identify beneficial owners of associated legal entities; however, certain brokers haven’t updated their anti-money laundering measures to comply with the 2016 rule. Through an investigation conducted by the Division of Examinations (EXAMS), the SEC observed that broker-dealers were inconsistent in the implementation of anti-financial crime policies and procedures and did not invest ample resources or staffing into their anti-money laundering programs.

31 July: WFE published its response to the International Organization of Securities Commissions (IOSCO) Policy Recommendations for Crypto and Digital Asset Markets. The WFE points out that the proposed recommendations do not define what a crypto asset is, making it challenging to apply corresponding regulations. Also highlighted is that the principle of 'same risk, same regulation' shall apply to minimize failures.

31 July: The D.C. Circuit reversed a ruling ordered by the SEC in 2020 that SPIKES Index securities be treated as futures rather than security futures, finding that the SEC did not adequately explain its reasoning behind the change.

31 July: The SEC asked Coinbase to halt trading in all cryptocurrencies other than bitcoin, revealing an effort to assert its regulatory authority over the market. The exchange previously rejected the SEC’s recommendation to delist the over 200 tokens that they offer.

28 July: An Indian market regulator, who requested anonymity, plans to propose new measures to reduce derivative risks for retail investors trading equity derivatives. These measures will potentially connect the amount of derivatives trading allowed to an investor’s wealth, protecting smaller investors from potential losses during market volatility. Previously, the regulator urged brokers to highlight risks associated with derivatives trading on their websites but are now exploring stricter measures such as tracking and controlling “disproportionate trading.”

26 July: The SEC voted to propose new requirements that would hold algorithms that predict, guide, or forecast investors’ behavior. Retail investment firms such as Robinhood Markets are utilizing predictive data analytics to encourage customers to trade, and the SEC’s goal is to prevent these emerging technologies from undermining firms’ legal obligation to act in the best interest of their clients.

25 July: IOSCO endorsed the ISSB’s Sustainability-related Financial Disclosures Standards. IOSCO now calls on its 130 member jurisdictions to consider ways in which they might adopt, apply, or otherwise be informed by the ISSB Standards within the context of their jurisdictional arrangements in a way that promotes consistent and comparable climate-related and other sustainability-related disclosures for investors.

25 July: The United States Government Accountability Office (GAO) conducted a report revealing a significant regulatory gap for crypto assets. The Treasury’s Financial Stability Oversight Council has been tasked to lead the development of a unified approach to crypto asset oversight.

21 July: The Government of Namibia signed a law (Namibia Virtual Assets Act 2023) to regulate the Virtual Asset Service Providers operating in the country, revising the original decision in 2017 to ban cryptocurrency exchanges. Under the law, Namibia will provide licensing and regulation of virtual asset service providers.

Fines & Enforcement Actions

The SEC charged British billionaire and Tottenham Hotspur football club owner Joseph C. Lewis for insider trading, including 16 counts of securities fraud and three counts of conspiracy. Lewis is alleged to have breached a duty of confidentiality by illegally tipping material nonpublic information to friends and associates.

The SFC fined China Industrial Securities International Brokerage Limited (China Industrial) $3.5 million for internal control failures involving suspicious trading monitoring and client order documentation. The SFC’s investigation revealed China Industrial’s lack of proper execution of its internal policy on post-trade monitoring, leading to inadequate examination of flagged transactions during certain periods; the firm also failed to comply with regulatory guidelines on recording telephone order instructions. The SFC took China Industrial’s clean record and cooperation into account when deciding the disciplinary sanction.

The SEC and the Commodity Futures Trading Commission (CFTC) distributed combined penalties to 11 Wall Street firms, including Wells Fargo, BMO Capital Markets, and Mizuho Securities, totaling about $550 million for recordkeeping and supervision failures.

The SEC charged a Florida resident and various entities he managed for fraudulently raising approximately $35 million from at least 60 investors – most of whom were elderly, retired, and connected to a church where he was an active .

The CFTC issued an order against a U.K.-based trader for engaging in multiple instances of spoofing. The trader’s approach involved placing bids and offers for West Texas Intermediate (WTI) futures with the intention of canceling these orders before they could be executed. The trader is required to pay a $150,000 civil penalty and faces a one-year trading ban on any CFTC-designated exchanges/registered entities and in all commodity interests.

The Prudential Regulation Authority (PRA) fined Credit Suisse International and Credit Suisse Securities £87 million for failures in risk management and governance; this is the PRA’s highest fine and only instance of the enforcement investigation breaching four of the PRA’s fundamental rules.

The Federal Reserve Board announced a consent order and a $268.5 million fine with UBS Group AG of Zurich, Switzerland, for misconduct by Credit Suisse. Credit Suisse participated in unsafe counterparty credit risk management practices with a former counterparty.

Israel Securities Authority imposed sanctions on “spoofing” activity in TASE trading following violations committed by an individual investor and a trader employed by Rostami. The pair engaged in proprietary day trading, setting a precedent for sanctions to be imposed on fraudulent persuasion of this category., setting a precedent for sanctions to be imposed on fraudulent persuasion of this category.

The SFC charged individuals, including two core members of a large-scale syndicate, with market manipulation involving ramp-and-dump stock investment schemes and with conspiracy to defraud in transactions involving securities. 

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