FINRA Rule 5320, Prohibition Against Trading Ahead of Customer Orders, will be replacing NASD IM-2110-2, Trading Ahead of Customer Limit Order, and NASD Rule 2111, Trading Ahead of Customer Market Orders.  New FINRA Rule 5320, which was approved by the SEC in February and takes effect on 9/12/11, consolidates, updates and simplifies the current standards. 

FINRA Rule 5320 generally provides that a member firm that accepts and holds an order in an equity security from its own customer or a customer of another broker-dealer without immediately executing the order is prohibited from trading that security on the same side of the market for its own account at a price that would satisfy the customer order, unless it immediately thereafter executes the customer order up to the size and at the same or better price at which it traded for its own account.

        Market and Limit Orders Affected.   Rule 5320 applies to customer market and limit orders in securities that meet the definition of “OTC Equity Security” as defined in FINRA Rule 6420, as well as securities that meet the definition of “NMS stock” as defined in Rule 600 of SEC Regulation NMS.  With respect to customer limit orders - marketable and non-marketable - as was the case with NASD IM-2110-2, FINRA Rule 5320 includes minimum price improvement amounts that are necessary for a firm to execute an order on a proprietary basis when holding an unexecuted limit order in that same security, and not be required to execute the held limit order (unless an exception applies). 

The Supplementary Material to Rule 5320 provides several exceptions, including:  (i) large orders and orders from institutional accounts;  (ii) a “no-knowledge” exception;  and, (iii) trades made to offset a customer odd-lot order or to correct a bona fide error.

        Large Orders and Institutional Account Exceptions.   Rule 5320.01 generally continues to permit firms to negotiate terms and conditions on the acceptance of certain large-sized orders (10,000 shares or more, and greater than $100,000 in value) and orders from institutional accounts (as defined in NASD Rule 3110(c)) that would permit firms to trade ahead of or along with such orders, provided that firms give clear and comprehensive written disclosure to such customer at account opening and annually thereafter that:

• discloses that the firm may trade proprietarily at prices that would satisfy the customer order, and
• provides the customer with a meaningful opportunity to opt in to the Rule 5320 protections with respect to all or any portion of its order.

In lieu of providing the written disclosure to customers at account opening and annually thereafter, Rule 5320.01 would permit firms to provide clear and comprehensive oral disclosure to, and obtain oral consent from, a customer on an order-by-order basis, provided that the firm documents who provided the consent and that the consent evidences the customer’s understanding of the terms and conditions of the order.  When a customer has opted in to the Rule 5320 protections, a firm may still obtain consent on an order-by-order basis to trade ahead of or along with an order from that customer, provided that the firm documents who provided the consent and that the consent evidences the customer’s understanding of the terms and conditions of the order.

        No-Knowledge Exception.   Rule 5320.02 provides an exception for a firm’s proprietary trading in NMS stocks where the proprietary trading unit does not have knowledge of the customer order.  Specifically, if a firm implements and uses an effective system of internal controls - such as appropriate information barriers - that operate to prevent one trading unit from obtaining knowledge of customer orders held by a separate trading unit, those other trading units trading in a proprietary capacity may continue to trade at prices that would satisfy the customer orders held by the separate trading unit.

If a firm structures its order-handling practices in NMS stocks to permit its market-making desk to trade at prices that would satisfy customer orders held by a separate trading unit, the firm must disclose in writing to its customers, at account opening and annually thereafter, a description of the manner in which customer orders are handled by the firm and the circumstances under which it may trade proprietarily at its market-making desk at prices that would satisfy the customer order.

With respect to OTC Equity Securities, if a firm implements and uses an effective system of internal controls, such as appropriate information barriers, that operate to prevent a non-market-making trading unit from obtaining knowledge of customer orders held by a separate trading unit, the non-market-making trading unit trading in a proprietary capacity may continue to trade at prices that would satisfy the customer orders held by the separate trading unit. The no-knowledge exception does not extend to the market-making desk for trading in OTC Equity Securities.

        Odd Lot and Bona Fide Error Transaction Exceptions.   The rule provides an exception for firm proprietary trading made to offset a customer order that is in an amount less than a normal unit of trading (an “odd lot”).  In addition, a transaction made to correct a bona fide error also is excepted. Firms are required to demonstrate and document the basis upon which a transaction meets the bona fide error exception.

        Trading Outside Normal Market Hours.   Supplementary Material .08 of Rule 5320 clarifies that the rule applies to a customer order at all times that the order is executable by the firm. Therefore, while firms generally may limit the life of a customer order to the period of normal market hours of 9:30 a.m. to 4:00 p.m. ET, if the customer and firm agree to the processing of the customer’s order outside normal market hours, then the protections of this rule also apply to that customer’s order outside of normal market hours.  

For further details, go to:   [FINRA RegNote 11-24, May 2011]