The trade allocation compliance function is getting more visibility as supervisory bodies have intensified their attempts to combat misconduct by firms in trade allocation practices.
2. Trade allocation: Asset managers’ need for a robust Compliance function 2
» Understanding the need for effective
compliance in the trade allocations process
» Best practices to mitigate violations
resulting from trade allocations
» Common types of trade allocation
methodologies
» Present-day workflow management
» Noteworthy regulatory cases
» How can Acuity Knowledge Partners help?
KEY
INSIGHTS
3. Trade allocation: Asset managers’ need for a robust Compliance function 3
Introduction
Asset managers are required to determine, on a day-to-day basis, how to assign
security trades ordered for their funds or client accounts, a process generally
referred to as trade allocation. Trade allocation and the order aggregation process
are carried out by investment advisers/asset managers, where securities traded
have to be re-allocated from a pool account en bloc to various sub-accounts
(tranches) that belong to the same composite/trading strategy.
In order to facilitate the best execution, orders need to be aggregated where: (a) all
orders for the same security and identical execution criteria arriving at the trading
desk are placed at approximately the same time through a block order or (b) orders
that arrive at the dealing desk for the same stock with identical execution criteria
but at different times can also be aggregated/merged if the trade execution for the
first (prior) order has not started (for example, due to the market having not been
opened yet).
Life of a Trade
Trade Processing
Order Management
Trade Allocation
Trade Agreement
Order
(T-n) Day
Execution
T Day
Settlement
T+2 Day / T+3 Days
Clearing
T+1 Day
Reference Source: BNY Mellon
4. Trade allocation: Asset managers’ need for a robust Compliance function 4
Why is trade allocation monitoring required?
Since trade allocations require the breaking down of
aggregated or block trades in the underlying client
accounts being managed by investment advisers, the
firm should make sure that trade allocation practices
carried out are unbiased and egalitarian. There is a
fiduciary duty to make sure a scrupulous compliance
monitoring process is in place, since trade allocation
slip-ups can lead not only to bad investment results
for their client accounts but also draw the wrath of
regulators.
Regulators such as the Securities and Exchange
Commission (SEC) and the Financial Conduct
Authority (FCA) have made a point of enforcing action
against “favouring”, which occurs when the trading
desk allocates trades with advantageous results to
preferred accounts and trades with inferior results
to other clients and/or in uneven proportions. These
trade allocation irregularities are typically found
with investment advisers who manage performance
fee accounts or proprietary or personal employee
accounts alongside non-performance fee accounts.
Also, it makes it tough for clients to detect, as the
advisers ordinarily make the allocations after the
trades have been executed. Regulators are also
against practices such as “quid pro quo”, where the
payment of superior or better commissions receive a
higher amount of allocation.
The SEC uses Section 206 (Prohibited Transactions
by Investment Advisers sub-sections [1] and [2]),
Rule 206(4)-7 (Compliance Policies and Procedures)
of the Investment Advisers Act of 1940 and Section
10 (Manipulative and Deceptive Devices sub-section
[b]) of the Securities Exchange Act of 1934 to impose
fines and penalties against the carrying out of inapt
trading practices. Likewise, the FCA uses Conduct
of Business Sourcebook - Section 11.3 (client order
handling) to enforce regulatory requirements.
Therefore, having a robust and inclusive trade
allocation policy should be an elementary requirement
for a compliance-prudent firm.
In order to make sure trade allocation practices do not
favour anyone, a complete and veracious disclosure of
theallocationpoliciesandpreservationofsatisfactory
books and records are vital, as regulators have, as of
recent, intensified attempts to combat misconduct in
trade allocation practices.
5. Trade allocation: Asset managers’ need for a robust Compliance function 5
Best practices to mitigate violations resulting
from trade allocations
Although regulators do not explicitly provide
instructions on any specific allocation practice
or methodology to be adhered to, a compliance-
conscious firm must consider the below key practices
to avoid trade allocation violations:
1. Clear, unambiguous and complete trade allocation
policies and procedures.
2. A standard allocation methodology (pro-rata
allocation, rotation-based, etc.) for trades.
Even though pro-rata methodology is the most
frequently used, the appropriateness of any
particular method will generally depend on the
investment manager’s trading strategy.
3. Being uniform (for example, not changing
allocation policies on methodology frequently).
4. Disclosing and appropriately communicating to
all parties (clients) on changes being made to
allocation policies/methodologies, etc., since
there have been a number of enforcement actions
by regulators, wherein the advisers do not fully
disclose the activity or changes to their clients.
There should be full disclosure in the adviser’s
Form ADV (Uniform Application for Investment
Adviser Registration).
5. Documenting how trades are being allocated,
especially when the adviser has to make ad
hoc decisions. This is for the purpose of having
supporting documentation to provide facts and
rationale. If documentation is not maintained, it
may cause unnecessary scrutiny from regulators/
auditors, as the details could be forgotten with the
passage of time between when such decisions
are made and when the regulator/auditor inquires
about them.
6. Theadvisershouldnotbeaggregatingtransactions
unless it believes aggregation is consistent with
seeking the best execution and also with the
terms of the adviser’s Investment Management
Agreement with each client participating.
7. Avoiding preferential treatment or cherry picking
by not favouring certain clients in a limited
investment opportunity. In addition, each client
account that participates in an aggregated order
should participate at the average share price for
all the adviser’s transactions in that security, with
the transaction costs shared on a pro-rata basis.
8. Prior to entering into an aggregated order, the
adviser should prepare a written statement,
specifying the participating client accounts and
how it intends to allocate the order among the
client accounts. Also, the adviser’s books and
records should distinctly reveal, for every client
account, the orders that are aggregated and
the securities that are held, bought and sold for
participating accounts.
It is also essential to note that valid exceptions to
deviate from the standard allocation practices are
acceptable – such as odd lot quantity exemption
for the security being purchased, accounts not
participating because they have dissimilar investment
strategies, the Investment Policy Statement having
unique restrictions (for example, not allowing to invest
in “sin” stocks) or the account having considerably
higher or lower cash balances due to subscription or
redemption activities. A partial fill on a block order
would also be a cause for not being able to allocate
certain client accounts on a pro-rata basis.
It would be ideal if the trading, portfolio management
and compliance teams review trade allocation reports
periodically (daily, weekly, monthly, etc.), wherein
the report shows all allocations and any exceptions
with respect to the standard guidelines for the time
period under consideration, so that reviewing this
information and examining the exceptions enables
the firm to identify and resolve any trade errors that
arise from trade allocations in a timely and accurate
manner.
6. Trade allocation: Asset managers’ need for a robust Compliance function 6
Common types of trade allocation
methodologies
There are multiple trade allocation methodology types
that investment advisers can use for allocating for
fully and/or partially filled trades. The suitability would
be subject to the trading strategy being used. Some of
the common ones are as follows.
1. Pro-rata allocation: This is the most widely used
methodology, where trades are allocated on a
proportionate basis. The splitting of allocation
quantity between composite accounts of the
total executed quantity will sum up to constitute
the total. Example: If there are 3 accounts in a
composite, the total executed quantity is 100 units
and the pro-rata allocation is 10/30/60 (based
on the portfolio size of composite accounts),
the allocated quantity among the accounts
will sum back to the total executed quantity.
2. Rotation of accounts: This methodology involves
accounts to be allocated in systematic cycles.
Example: If there are 3 accounts trading in a
composite/trading strategy, during the first
phase of the cycle, Account 1 will receive the
most advantageous fill, Account 2 will receive the
second-most advantageous fill and so on. In the
second phase of the cycle, Account 2 will receive
the most advantageous fill and Account 1 will move
to the end and receive the least advantageous fill.
3. Random allocation: This is generally based on a
computer-generated random order of accounts.
The best price is allocated to the first account on
the computer-generated list and the worst price
is allocated to the account that is last on that list.
4. Highest prices to the highest account
numbers: Accounts are ranked in order of
their account numbers. The highest fill prices
are allocated to the account with the highest
account number. Any “gain” that the higher
numbered account gets on the “sell” orders is
offset by the “loss” it gets on the “buy” orders.
5. Average price: During split fills, the average price
is calculated by the system for every bunched
order, and the average price is thereby assigned
to each allocated contract. This allocation method
offers an unbiased and uniform way of allocating
trades.
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