1. Broker-dealer industry hot topicsHighlights from Grant Thornton LLP’s broker-dealer industry symposiumOn June 19, 2012, Grant Thornton hosted a panel discussion The panelists addressed a number of current issues facingon the major issues facing the broker-dealer industry. The the broker-dealer industry. The issues discussed includeddiscussion was hosted by Nichole Jordan, the firm’s National environmental pressures, changes in the regulatory atmosphere,Banking and Securities Industry leader. It was moderated enhanced customer protection rules, and margin changes andby Lee Pacchia, legal analyst and host of Bloomberg Law technology changes, including the use of social media.multimedia programs. The panel comprised several broker-dealer industry professionals, including these industry experts: Environmental pressures The discussion stressed that the two major drivers that impact• Steven Lofchie, partner, Cadwalader the industry relate to the inability of broker-dealers to address• Kevin Piccoli, deputy director, Division of Swap Dealer and liquidity and collateral certainty. Effective implementation Intermediary Oversight, U.S. Commodity Futures Trading of the rulemaking and regulatory initiatives discussed here is Commission (CFTC) dependent on adequately addressing these issues.• Lanny A. Schwartz, partner, Davis Polk & Wardwell LLP• Grace Vogel, executive vice president of member regulation, Financial Industry Regulatory Authority (FINRA) The following are edited transcripts and summaries of paneldiscussions from the conference. In all cases, the speakers’comments represent their own views and are not necessarilythose of their respective organizations, Grant Thornton LLP orits clients, or any other entity. The information provided maynot and should not be construed to imply endorsement or evensupport by Grant Thornton LLP of the views expressed herein.
2. Broker-dealer industry hot topics• Basel III – Recent financial crises have highlighted • Dodd-Frank implementation (Uniform Fiduciary weaknesses in the global regulatory framework for financial Standard) – Under Dodd-Frank, the SEC is mandated to firms. As a result, the Basel Committee on Banking study the need for establishing a uniform federal fiduciary Supervision has adopted the global regulatory standard standard of care for broker-dealers and investment advisers known as Basel III. It covers bank capital adequacy, stress who provide personalized investment advice. According to testing and market liquidity risks. The Basel III initiative Vogel, FINRA believes a fiduciary standard is appropriate will put increased pressure on broker-dealers’ profitability, for all customers, including brokerage customers. However, particularly on returns on equity (ROE) given the increased FINRA does not believe every client is suitable for a fee- capital and margin requirements. Balance sheets will also be based account, which may result in higher charges, and does reduced because of increased leverage requirements. believe clients should have the option to have a self-directed account for which they are charged on a commission basis. One of the challenges broker-dealers are facing under Basel In a fee-based account, the customer is generally charged III is how to replace or increase their revenues to maintain separately for each service provided, while a commission the ROEs that shareholders have come to expect. From charge is incorporated into the transaction itself. a sales practice perspective, regulators are concerned that new products originally developed for institutional clients The proposed Investment Adviser Oversight Act suggests are now being sold to retail customers, which may not be shifting the regulation of investment advisers from the SEC appropriate for them. According to Panelist Grace Vogel, to FINRA. Panelist Lanny Schwartz indicated that the topic while all the regulations governing the securities business of self-regulation for investment advisers has been around took many years to develop, the regulations governing for many years. He agrees that there are important customer the derivatives space evolved over a much shorter period benefits. This was highlighted in part by the Madoff crisis, of time. And, she observed, as swaps move to execution when the principal regulator — the SEC — did not have facilities and central clearing under the new guidelines, sufficient manpower to perform timely examinations of margins to dealers will be dramatically reduced. the more than 12,000 advisers. (The SEC did perform an audit of the Madoff broker-dealers, although the extent of Regulators have been challenged to find the appropriate the clients who had invested in Madoff-managed accounts model to determine the amount of capital that has to be through other advisers was the examination failure issue.) maintained by broker-dealers. The value-at-risk model for According to Schwartz, as the broker-dealer and investment trading assets is currently in use, but according to Vogel, advisory businesses converge, utilizing FINRA as the self- that model presents challenges because it is accurate only regulatory organization (SRO) for investment advisers 99 percent of the time. This means that one out of every would promote a common set of standards and approaches 100 days will result in a loss that exceeds the model, Vogel for examinations. While the SEC has revised its custody said. As a result, the SEC and the CFTC have set minimum examination requirements, installing an SRO would support capital requirements. Under its Consolidated Supervised improvements to investment adviser examinations. Entity program, the SEC required that broker-dealers have at least $5 billion in tentative net capital (i.e., net liquid assets). However, this proved to be insufficient in the case of Lehman Brothers in 2008, when a lack of liquidity exposed the firm’s inability to realize the measured fair value. Vogel indicated that FINRA is now placing much more focus on liquidity, asking firms to maintain sufficient liquidity at the The proposed Investment Adviser Oversight broker-dealer level rather than at the holding company, and to perform stress testing to ensure liquidity is available when Act suggests shifting regulation of investment needed. While currently there are no definitive SEC rules advisers from the SEC to FINRA. governing liquidity, Vogel expects to see some liquidity rules for securities-based swap dealers proposed this summer.
3. Broker-dealer industry hot topics• JOBS Act regulation – The Jumpstart Our Business • Segregation and secure control locations for customer Startups (JOBS) Act that was recently passed by Congress funds – Piccoli said that the CFTC will be recommending brings two major reforms to securities law: changes to the changes to the method of computation for secured funds. IPO process and facilitation of capital access to private FCMs should be using the net-liquidating equity method companies. But what are the consequences for broker- to compute the secured amount versus the alternative dealers on the research side? Panelist Steven Lofchie sees a method, which can leave any unused portion of customers’ contradiction in the regulation; for example, the CFTC has funds exposed to loss. Piccoli indicated that the CFTC will been tightening its regulation of institutional research on be issuing a letter to FCMs in the near future, addressing interest rates and FX, while the SEC is deregulating research computation methods. He expects some regulations on emerging growth companies meant for retail investors. regarding secured funds to be forthcoming. He also Schwartz pointed out that the legislation is an example of mentioned that the CFTC is contemplating whether FCMs the trade-offs that come with securities regulation, because should be required to disclose the location of the secured the JOBS Act may allow small businesses to more easily assets and to what extent that location should be made raise capital and access the IPO market. available to the public.• Uncertainty regarding the Volcker Rule – The Volcker • Proposed elimination of credit ratings in SEC rules – Rule has created uncertainty for financial institutions and Under Dodd-Frank, the SEC has proposed removing the financial markets in general. Lofchie sees difficulty references to credit ratings within the credit agency rules in regulating non-U.S. financial institutions because that and, where appropriate, replacing them with an alternative effort may negatively affect international relations with standard of creditworthiness. Vogel said that no-action these institutions and could affect U.S. jobs. He also sees letters making reference to credit ratings will continue to diminished liquidity and widening spreads in the market. exist, but the SEC is planning to change the language where On the other hand, Vogel does not believe liquidity will be reference is made to a nationally recognized statistical rating affected, indicating that there are many market makers that organization. can provide liquidity not subject to the Volcker Rule. • Importance of broker-dealers’ custody practices – Lofchie• Risk review update – Panelist Kevin Piccoli indicated that emphasized the importance of the custody rule for broker- liquidity is one of the main risk factors driving firms into dealers and advised firms to take a closer look at their foreign troubled situations. He anticipates pressure on U.S. firms, control location agreements. He added that the treatment of particularly the parent companies of futures commission affiliate accounts is a very important issue. Vogel commented merchants (FCM), as a result of downgrades on some banks that there have been instances in which firms have lost coupled with the European situation. It is important to significant amounts of money because they did not review understand the risk elements in order to keep customers’ transactions closely enough; the transactions were masked funds safe and secure. From an examination standpoint, because they were done on an intracompany basis. Piccoli noted that the CFTC will be taking a closer look at the risk profiles of firms and the effect on customers.
4. Broker-dealer industry hot topicsAdditional areas of focus • Proposed additional documented procedures for clearing• FINRA Rule 4524 (Rule 4524) – Rule 4524 allows FINRA firms – Proposed FINRA Rule 4516 will require clearing, to collect information supplementary to the Financial and carrying and self-clearing firms to store certain records Operational Combined Uniform Single (FOCUS) report. (e.g., lists of responsible parties, access letters to all control According to Vogel, the FOCUS report is an SEC form, locations, detailed procedural write-ups) in a centralized first approved in the mid-70s, that has become outdated. physical location at the principal office to enable regulators The SEC has recently approved Rule 4524, which allows to take prompt action to protect investors in the event of a FINRA to collect information supplementary to the liquidation. After receiving comments from member firms, FOCUS report. Each form must go through the comment FINRA is making some modifications to the proposed rule, period and rulemaking process; the first form that was including narrowing the universe of firms subject to the rule. approved is a detailed income statement that must be filed by every firm on a quarterly basis, with the first filing due • Use of social media and areas of concern – With the for the period ending Sept. 30, 2012. This information will proliferation of social media use by broker-dealer personnel, give FINRA a better understanding of how the firm is FINRA has developed detailed guidance for member firms. making money and what its expenses are. FINRA will also Any communication made with the public falls under SEC require additional information from firms that, during a rules and must be supervised and retained by the broker- reporting period, derive more than 10 percent of their total dealer. A registered principal (principal) must approve the revenues from participation in unregistered offerings. use of any social media site prior to its use by an associated person. Any communication that recommends certain The second form, which is applicable only to carrying and products may trigger the suitability rule, and additional clearing firms, is a proposed supplemental off-balance sheet disclosures may be required. Certain social media meet schedule, designed to give better insight to off-balance the definition of a public appearance, such as participation sheet items. In the case of MF Global, several risks were in online forums, chat rooms and seminars. While these not detected because they were off-balance sheet items actions do not need prior approval, a post-review would be and were identified only after the annual audited financials required. Blogs that contain certain static content fall under were released. There were some concerns regarding the the SEC’s advertising rules and require principal review confidentiality of the schedule, but Vogel assured the prior to use. Use of Facebook, Twitter and LinkedIn also audience that FINRA does not make the FOCUS report need to be supervised, and depending on how the associated available to the public, and therefore would not make the person is using them, may require pre- or post-review. supplemental schedule available either. Third-party posts are also an area of concern because they could be attributed to the firm. Any links to a third- party also raise concerns because these sites may contain misleading or incorrect information. The use of personal devices by broker-dealer personnel is also an area of uneasiness. Vogel referred to it as “Bring Your Own Device” because many firm personnel do not want to carry several devices and prefer to be able to access all of their work on their own personal device. The broker- dealer needs to be able to retain and supervise all of the activity on that device. Many firms are asking personnel to sign an annual attestation of compliance with firm polices.
5. Broker-dealer industry hot topics• Proposed efforts to increase customer protection – As • Creation of swap data repository and areas of concern self-regulatory organizations for the futures commission, the – Under Dodd-Frank, market participants — particularly National Futures Association and the Chicago Mercantile swap dealers — need to report certain data elements to a Exchange merchants have proposed rule amendments to registered swap data repository or the CFTC. The industry increase customer protection. In addition, Piccoli said the has many concerns about the structure, including the CFTC is expecting each firm’s chief compliance officer ability of firms to gather all the information required in the (CCO) to take an active role in ensuring the right areas are time frame put forth by the rule. There are also concerns being reviewed. The CFTC is proposing that CCOs of swap about the swap data repositories themselves, including dealers and FCMs perform an annual certification stating that how they operate, what their technical standards are and policies, procedures and controls have been reviewed and the security of the data. Given the complexity of the swaps are in position. This proposed rule is similar to FINRA Rule data, Schwartz voiced concern over how intelligible the 3130, which requires CEOs or their equivalent to annually information will be and how market participants will be certify firm compliance policies and supervisory procedures. required to use it. The CFTC will also be focusing on the amount of excess in the funds required to be segregated or secured. This amount • Information learned from the May 6 flash crash – On is traditionally viewed as the cushion, or as Piccoli called it, May 6, 2010, the Dow Jones fell almost 700 points in less the target level. Firms will now be required to disclose how than 30 minutes in an event dubbed the “flash crash.” the target level is determined, and they will be required to Pacchia asked what we have learned from it. Vogel indicated notify the CFTC if there are changes in the level, and why. If that there is a more rational uptick rule that should prevent more than 25 percent of the excess is withdrawn, this action the same thing from happening again, as well as SEC Rule must be approved by the CEO or CFO. 15c3-5, which is the direct-market access rule requiring firms to put controls in place.• FINRA Rule 5310 (Best Execution Rule) – FINRA Rule 5310 (Rule 5310) is the new consolidated rule governing • High-frequency traders (HFT) and potential restrictions members’ best execution requirements. Moderator Lee – According to Vogel, HFTs argue that they provide Pacchia asked whether Rule 5310 will provide more comfort liquidity to the market. However, she said it is often difficult to investors, and if regulators are focused on the right issues. to distinguish between an HFT and a market maker. Lofchie Lofchie feels that the equity markets are incredibly efficient, feels that the SEC has taken away a lot of the incentive to with very little fluctuation in price one way or another. be a market maker, and by default, the HFTs have become Additionally, Lofchie feels there are other issues, such as market makers. liquidity, that are more deserving of attention from firms and regulators. From a regulatory perspective, he thinks that best execution practices are a relatively low regulatory priority.Given the complexity of the swaps data, Schwartzvoiced concern over how intelligible theinformation will be and how market participantswill be required to use it.