[ by Howard Haykin ] FINRA proposes to adopt NASD IM-2110-3, Front Running Policy, as new FINRA Rule 5270 with certain changes.  FINRA submitted the proposal to the SEC in FINRA Rule Filing 12-25 on 5/17/12. Background Into The Front Running Policy. The policy was adopted as interpretive material to Article III, Section 1 of the NASD’s Rules of Fair Practice in 1987, states that it is considered conduct inconsistent with just and equitable principles of trade for a member or an associated person of a member to buy or sell security futures or certain options for accounts in which the member or associated person has an interest when the member or associated person has material, non-public market information concerning an imminent block transaction5 in the underlying security.

Similarly, the same prohibition applies in the underlying security when the material, non-public market information regarding a block transaction concerns an option or security future on that underlying security.  The Front Running Policy also prohibits providing material, non-public market information concerning an imminent block transaction to customers who then trade on the basis of the information.  The Front Running Policy is limited to transactions in equity securities and options that are required to be reported on a last sale reporting system and to any transaction involving a security future, regardless of whether the transaction is reported.

The prohibitions apply until the information concerning the block transaction has been made publicly available (i.e., “when [the information] has been disseminated via the tape or high speed communications line of one of those systems, a similar system of a national securities exchange under Section 6 of the Act, an alternative trading system under Regulation ATS, or by a third-party news wire service”).

Finally, the Front Running Policy includes exceptions from the general prohibitions in the rule for “transactions executed by member participants in automatic execution systems in those instances where participants must accept automatic executions” as well as situations  where a member receives a customer’s block order relating to both an option or security future and the underlying security and the member, in furtherance of facilitating the customer’s block order, positions the other side of one or both components of the order. In the latter case, a member is still prohibited from covering any resulting proprietary position by entering an offsetting order until information concerning the block transaction has been made publicly available.

SIFMA Comments. Sean Davey, an MD for SIFMA's Corporate Credit Markets Division, submitted the comment letter on behalf of the industry organization. Back in 2009, SIFMA submitted extensive comment on FINRA’s earlier proposal.  However, after reading FINRA's 2012 proposal, it's apparent that SIFMA's comments and recommendations had little to no impact on FINRA's current proposal. This year, SIFMA will try to focus FINRA and the SEC on what SIFMA believes to be the most important flaw in the Proposal - namely that the barriers to resumption of trading in the applicable security or related financial instrument may interfere with broker-dealers’ risk management activities, and may create a barrier to providing liquidity to the market. Specifically, SIFMA is requesting that FINRA provide revisions and clarifications so as to ensure, the following:

• that broker-dealers retain the ability to engage in risk management and liquidity providing activities, both with respect to the specific transaction, and on a portfolio or similar basis,without violation of the proposed rule, and second, that firms have sufficient understanding of the

Proposal, and of the manner by which the proposed rule will coexist with related regulation and interpretive guidance.  Finally, SIFMA requests a greater implementation period in order to commence and complete the required modifications and related implementation of the proposed rule. II.       SPECIFIC COMMENT REGARDING THE PROPOSAL 2.1   The proposed provisions of FINRA Rule 5270 should be revised so that the transfer of risk from the customer serves as the trigger for lifting trading restrictions. Currently, the proposed rule allows a broker-dealer to resume trading in the security or related financial instrument when the information concerning the block transaction "has been made publicly available or otherwise has become stale or obsolete."  The 2009 Comment Letter described in detail certain of SIFMA’s concerns in respect of this standard, and in its response to comments FINRA has clarified but largely left intact the "stale or obsolete" standard.  The purpose underlying the proposed rule is, as noted in the Proposing Release, that "firms should not use their knowledge of imminent block transactions to benefit themselves at the expense of their customers."  Given this underlying purpose, SIFMA’s view is that the proposed rule be revised to incorporate a "transfer of risk" standard.  Specifically, trading restrictions under the proposed rule  should be lifted once the risk of the transaction has been transferred from the customer through execution of the applicable order. In the context of a block transaction that a member executes as principal, the member has assumed the risk of the transaction.  Providing liquidity to the market through the assumption of risk is a valuable service to customers and the market, and one that satisfies the proposed rule’s purpose that the interests of the customer should be placed ahead of  the interests of the member.  Once the risk has passed to the member, the member is trading in the applicable security or related financial instrument for its own account.  Similarly, in the context of a block transaction where a member executes as agent, the  execution of the transaction eliminates the opportunity for the member to trade ahead of the customer, or more generally, to put its interests ahead of its customers’ interests by trading ahead of the execution of the customer order. Our market structure does not provide for real-time trade reporting across products.  Accordingly, undue reliance on a "staleness" threshold that incorporates delays by current construction – such as waiting for public dissemination – could prevent a dealer from performing necessary risk management  activities, and provides no additional benefit to  the  customer.  By comparison, determining that trading is permitted at the time that the risk of the transaction has been transferred from the customer creates a standard that is both objective and definite. SIFMA therefore requests confirmation that execution of the block transaction by the member as principal or agent will:

• Constitute fulfillment of the block order in accordance with Supplemental Material .04(b), or alternatively be deemed to render the non-public information stale and obsolete for the purposes of front running the customer; and
• Permit the broker-dealer to transact in the security or related financial instrument, subject to other existing law and regulation, even if the applicable principal transaction between the member and the customer, or the transaction by the member on behalf of the customer, has not become public.

A change to a risk transfer standard does not, of course obviate other existing obligations to act in a manner consistent with just and equitable principles of trade, to timely submit for transaction reporting  and  to  comply  with  other  similar  rules  designed  to  provide customer  and  market protections 2.2  Clarification of the relationship to other guidance, and implementation. NASD NtM 05-51 and NYSE IM 05-52 (the "Interpretive Guidance"), and FINRA Rule 5320 create obligations that are related to the proposed rule.  SIFMA is concerned that these overlapping rules create a web of obligations and exceptions that could be difficult to manage in practice.   However, these overlapping obligations can be read consistently, and SIFMA seeks the concurrence of FINRA and the SEC that such obligations will, wherever possible, be interpreted in a consistent manner.  As such, and for example, SIFMA therefore requests clarification that:

• The negative consent letter described at proposed Rule 5270.04 satisfies the "duty to refrain and disclose" described in the Interpretive Guidance; and,
• the duty to refrain and disclose described in the Interpretive Guidance arises on the basis of the same analysis as the obligations under proposed Rule 5270.

Such clarification will permit member firms to create parallel compliance systems for Rule 5270 as they have for the Interpretive Guidance. 2.3   Additional technology changes are required to comply with the proposed provisions of FINRA Rule 5270, and as such, additional time should be allotted in order to implement those changes. The Proposing Release provides that the proposed rule will become effective no later than 90 days following publication of a Regulatory Notice announcing Commission approval.  The breadth of the Proposal, including its expansion to fixed-income and OTC products, will in many cases require modification to technology and systems.  Further, in other cases the expansion of surveillance and supervision will also need to be coordinated with training and related implementation of internal procedures that could be difficult to manage within the 90-day time frame envisioned in the Proposing Release.  SIFMA therefore respectfully requests an implementation period of 180 days following the publication of the applicable Regulatory Notice. For further details, go to:  [SIFMA Comment Letter re: FINRA Rule Filings 12-25, 7/9/12].