When the Financial Industry Regulatory Authority (FINRA) recently published its “2019 Report on Examination Findings and Observations,” the regulator signaled a significant change was afoot. In this year’s examination report, FINRA revealed it is now much more serious about ensuring financial institutions and advisors comply with its rules regarding the use of technology systems—including those involving best execution and mark-up disclosures for fixed-income securities.

How can institutions and advisors be sure they are fully complying with FINRA’s new regulations? David Hsu, Chief Compliance Officer of 280 CapMarkets (www.280capmarkets.com)—a fixed income technology marketplace providing best execution support and price transparency to advisors, institutions, and issuers through its BondNav, spoke with Traders Magazine’s editor John D’Antona Jr. and offered some guidance.

TRADERS MAGAZINE:  Why did FINRA issue this report, and what is the upshot of its guidance?

David Hsu:  FINRA is very much aware of the proliferation of electronic trading systems and other technological innovations in the financial services arena, and wishes to encourage more of the firms under its supervision to adopt them in order to comply with its rules, including those related to fixed-income securities.

TM:  Can you explain what FINRA Rule 5310 is all about, and FINRA’s findings in relation to this rule?

Hsu:  FINRA Rule 5310 (Best Execution and Interpositioning) requires advisory firms to conduct “regular and rigorous” reviews of customer orders to make sure the best possible prices for the securities were achieved, and all trades can be justified to be in investors’ best interest. In its 2019 examination, FINRA found some firms did not compare their existing execution and routing arrangements with those of other venues to see if prices and quality could be improved.

The advent and proliferation of electronic trading platforms has made price discovery for fixed income much easier, and FINRA has made clear that firms should not solely rely on their clearing partners’ trading systems to execute every trade. As technology continues to improve, FINRA expects the institutions under its purview to leverage it to enhance their best execution programs—and integrate markets beyond their pre-existing clearing relationships in order to satisfy best execution.

For example, electronic communication networks (ECNs) generally display all available publicly listed prices for a particular security. However, that may not be the best price available and there may be additional negotiations that could derive a better price. The process could be compared to buying a car—the best deal you can get probably isn’t the one you find right off the Internet. To obtain a better price, you search for offers from multiple local car dealers, check the reputations of the different dealers, see what other features come with the car, and then you visit one of the vendors and begin to haggle.

TM:  How can financial institutions and advisors beef up their best execution programs to ensure they are in compliance with FINRA’s guidelines? 

Hsu:  Financial advisors and institutions can strengthen their best execution programs by partnering with technology providers, like 280 CapMarkets, that combine human capital behind technological innovation. In addition to aggregating and comparing prices from different bond market sources, prospective vendors should have capital markets teams that actually engage with institutional market sources, and reach out to various sources of liquidity (including those that don’t publish offers on electronic platforms), to negotiate and conduct deeper price discovery. Furthermore, while market orders can make sense for ease of execution, in today’s fast-moving marketplace advisors and institutions need to make sure execution isn’t compromised, and clients don’t receive less than they expect.

An electronic trading algorithm can locate the lowest price, but applying fixed-income market expertise to evaluate the best offer is the “X factor.”

Advisors and institutions should also make sure the fixed-income technology providers they consider partnering with prepare comprehensive documentation on best execution. As technology becomes more accessible and thus more commonplace, the days when firms can just pick up the phone and call three market-makers to prove they checked for best execution are over. To increase the chances of successful audits, brokers and advisors can work with a technology provider that compiles reports demonstrating how best execution was achieved for every single trade, and makes them readily accessible.

TM:  What did FINRA report in relation to Rule 2121?

Hsu:  In its 2019 report, FINRA found that some firms excluded additional charges from disclosed mark-ups and mark-downs, even when those fees reflected compensation. Other firms did not determine the prevailing market price for fixed-income transactions as ordered in FINRA Rule 2121, or disclosed times of execution on customer confirmations which did not match those determined by the Trade Reporting and Compliance Engine (TRACE) or the Electronic Municipal Market Access (EMMA) system.

Meanwhile, FINRA also reported that some firms were unclear or inaccurate in their labeling of registered representatives’ sales credits or concessions on customer confirmations, leading to confusion about the actual mark-ups.

TM:  What can firms do to ensure compliance with FINRA on mark-ups and mark-downs?

Hsu:  Advisors and institutions can solve for these challenges by utilizing a trade cost analysis (TCA) solution from a vendor which 1) comprehensively specifies, and communicates, the mark-up costs to investors, 2) aggregates data from multiple market sources in order to ensure a more accurate prevailing market price, and 3) accurately tracks, logs, and organizes time of execution, as well as representatives’ sales credits and concessions.

TM:  Is there anything else to keep in mind with regard to this FINRA guidance?

Hsu: As with everything in the regulatory world, there are caveats. Blindly relying on technology as the panacea to these findings is not good thing either. A well-balanced compliance program should incorporate technology, but should also incorporate human experience to interpret the red flags that the technology raises. Put another way, it takes a human to see the “forest through the trees” and decipher meaningful insights from the data.

TM:  What should financial institutions and advisors concerned about FINRA compliance look for in a technology provider?   

Hsu: As long as they work with a vendor that combines human expertise with technology, and provides tools to solve for compliance challenges outlined by FINRA, advisors and institutions can achieve peace of mind that they are doing right by their clients as well as their regulatory requirements.