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FINRA 2019 Priorities Letter (Part Three) – Operational and Financial Risks

January 23, 2019

by Howard Haykin


In its '2019 Priorities Letter', FINRA cites 2 areas of concern with regard to Operational Risks:
  • Supervision of Digital Assets Business
  • Customer Due Diligence and Suspicious Activity Reviews



In its '2019 Priorities Letter', FINRA cites 2 areas of concern with regard to Financial Risks:
  • Credit Risk
  • Funding and Liquidity



OPERATIONAL RISK - SUPERVISION OF DIGITAL ASSETS BUSINESS.    FINRA will not discourage firms from participating in activities related to digital assets – e.g., cryptocurrencies. It simply encourages those firms to notify FINRA if they plan to engage in such activities, even where a membership application is not required. In 2019, FINRA will review firms’ activities through its membership and examination processes related to digital assets and assess firms’ compliance with applicable securities laws and regulations and related supervisory, compliance and operational controls to mitigate the risks associated with such activities.


Coordinating closely with the SEC, FINRA will consider how firms determine whether a particular digital asset is a security and whether firms have implemented adequate controls and supervision over compliance with rules related to the marketing, sale, execution, control, clearance, recordkeeping and valuation of digital assets, as well as AML/Bank Secrecy Act rules and regulations.



OPERATIONAL RISK - CUSTOMER DUE DILIGENCE, SUSPICIOUS ACTIVITY REVIEWS.    FINRA will assess firms’ compliance with FinCEN’s Customer Due Diligence (CDD) rule, which became effective in May 2018. The CDD rule requires that firms: (i) identify beneficial owners of legal entity customers; (ii) understand the nature and purpose of customer accounts; (iii) conduct ongoing monitoring of customer accounts to identify and report suspicious transactions; and, (iv) on a risk basis, update customer information. FINRA will focus on the data integrity of those suspicious activity monitoring systems, as well as the decisions associated with changes to those systems.




FINANCIAL RISK - CREDIT RISK.    FINRA will review firms’ pols and procedures for identifying, measuring and managing credit risk, including risk exposures that may not be readily apparent. For example, a firm may be exposed to credit risk when it becomes responsible for transactions that its customers and correspondents execute “away” from the firm, without the firm’s participation until after execution.


Such responsibility can be incurred under clearing arrangements, prime brokerage arrangements, “give up” arrangements, sponsored access arrangements or principal letters. If sizable and conducted in a period of high volatility, trades under such arrangements may create large exposures for which the firm holds little or no collateral.


FINRA will also assess the extent to which firms identify and address all relevant risks when they extend credit to their customers and counterparties.


While a firm may believe that its margin requirements eliminate counterparty or customer credit risk, that firm can be exposed to sizeable losses in the event of a default by a customer whose margin account contains illiquid, volatile or concentrated securities positions. Similar risk exposures may exist when firms lend on products or strategies that have potential for large market moves, such as certain options strategies and structured products.



FINANCIAL RISK - FUNDING AND LIQUIDITY.    FINRA will continue to evaluate firms’ liquidity planning, including whether they have a reasonable process to regularly assess the adequacy of their liquidity pools and update their stress test assumptions based on changes in their businesses, products and customers. This year, FINRA will focus on whether firms update their stress test assumptions in light of changes in the marketplace, such as the increased volatility experienced at various points in 2018.


FINRA will also assess the adequacy of firms’ liquidity pools and their review of the reasonableness of stress test assumptions on a regular basis in light of all of their business activities and arrangements, including any arrangements where firms become responsible for transactions that their customers and correspondents execute “away” from them.



NOTE:   The above comments are not intended to be a comprehensive analysis of the issues addressed by FINRA in its 2019 Priorities Report, which can be obtained by accessing FINRA’s 2019 Priorities Report (click link below).