SEC/FINRA Officially Issues Warning on Unregistered Broker Dealers

Then why not just go w/ a registered b/d. Then you don't have to worry about what the SEC is considering

 

itrade2009 every posting you have is about how good jc trading is and you seem to put down other firms. just that thought was a bit funny. also looking at your old posts and you're the same guy as t0pd0g! haha that is funny when itrade2009 and t0pd0g talk to each other its really the same person. thats kind cool haha. same ip address wow! lol...

i just looked at all your past posting and all you seem to do is put down other firms and talk good about jc trading. if there is a link that you are with jc trading i think firms that is being slandered by itrade2009 should contact a lawyer just my 2 cents. just shut this jc trading manager down.

Also i heard paramount and cy both joined cbsx or in the process of being a bd right? also maybe ephinany as well not sure i do have a friend there though.

 

i do know of a lawyer in the securities business that deals with slandering of firms etc in the financial sector. pm me for his contact info in case you are ephiany trading owner or something.

 

First off...get a life....you don't know my IP address. Second, I guess I am a "Trade Manager" for Bright, Hold, and Echo as well!!

(see 3rd post)

http://www.elitetrader.com/vb/showthread.php?s=&postid=2794054#post2794054

 

Are proprietary trading firms that are registered as "non customer" broker-dealers – which the supposedly-good prop trading firms structure themselves as - mostly-exempt from FINRA's new & controversial red flag list? Maybe not.

Does non-customer BDs meet FINRA’s Regulatory Notice 10-18's definition of IBD, or a bona fide IA arrangement? My first thought is probably not, but I am speaking with some attorneys in the field and a few CEOs of these firms soon too. Plus I will ask FINRA as well.

If you watch these prop trading firms, it seems like they feel the heat from this FINRA Regulatory Notice. We heard from one CEO that the SEC was ready to pounce on the prop trading industry, following and reinforcing FINRA’s lead with Regulatory Notice 10-18. http://www.finra.org/Industry/Regulation/Notices/2010/P121248

FINRA issued Regulatory Notice 10-18 "Master Accounts and Sub-Accounts" in April 2010 to solidify existing rules and politely-remind clearing firms to help spot disguised customer accounts. After-all, many firms operate under the regulatory-radar and are not regulatory directly by FINRA, so regulators put more pressure and responsibility on their regulated companies to spot trouble.

Backdrop. For years, we have been following this continuing sage on our site and articles. Prop trading firms offer active traders an opportunity to trade the firm’s capital with leverage which is far-greater than the maximum 4:1 allowed on retail “customer account” pattern-day-trader accounts (Reg T margin rules). The prop trading - or “day trading” industry as it used to be known in the old days - has struggled to stay one-step ahead of regulators and the IRS for how they structure their arrangements with traders and tax matters too. Reg T and potentially-disguised customer accounts remains one of the biggest issues. Tuco was one of the flagship blow-ups over a year ago. I also wrote about my concerns of some firms mixing education programs with prop trading, which I also felt was being done to evade the regulatory and tax heat.

In FINRA Regulatory Notice 10-18’s red flag list of 10 bullet points, number 10 states that bullet points 3,4,5,6,8 and 9 would not apply for IBDs or a bona-fide IA arrangements described in the Notice. But can a non-customer BD claim this exemption as an IBD? Maybe not.

Several prior posts on this elite trader thread indicate that registered BDs are mostly exempt and okay on this Notice. My first thought is to disagree. But I could be wrong and I will find out soon.

The Notice states, "Similarly, in omnibus clearing arrangements, a broker-dealer that is registered with the SEC pursuant to the SEA 1934 (referred to as a "registered IBD") may procure clearing services for the customer accounts it services on a basis in which the identities of the sub-account owners are not disclosed to the clearing broker-dealer." …That FINRA will allow in these limited cases for the clearing firm to rely on the IBD and bona-fide IA’s own compliance work.

The above quote and Notice indicates a customer IBD procures clearing services "on omnibus clearing arrangements" for customer accounts, but again the non-customer BD does not have customer accounts.

In my view, the Notice is saying the omnibus clearing firm doesn't have to do repetitive compliance work if it’s already been done on the same level on the source customer accounts by the customer IBD. I don’t think that non-customer BDs subject their prop traders to this higher-level of compliance (I could be wrong?) and therefore, I wouldn’t think this Notice intends to exempt non-customer BDs. Again, I will call the people on the notice tomorrow to ask.

If I am right about non-customer BDs, will some firms try to mix up prop trading with the hedge fund and managed account model, in order to claim exemption as bona-fide IAs?

Recall that WorldCo went bust and had regulatory trouble years ago, one reason being they tried to mix the prop trading and hedge fund models. I heard some prop trading firms are planning new offerings that sound vaguely-like a hedge fund or managed account/prop trading hybrid too. I wondering if this is why they are pursuing those products and services?

Prop traders are active traders making their own trading decisions, they are not passive investors. Plus, these prop trading firms are not registered investment advisors. Going that bona-fide IA route seems far fetched too.

I just wanted to get my oar in the water on this and I will start rowing more soon. In the past, technical readings of the law by various attorneys supported industry positions that I still raised questions about. Some people just wait until regulators pounce. Just be smart about “is your money and trading access safe” issues.

If it walks and quacks like a duck, maybe it’s a “customer account” duck and the regulators will want it to be treated as such. This story has been developing for over a decade and why now for any beating down by regulators? Fin Reg is huge now and regulators are feeling the heat from Congress to do their jobs to protect the investing public. They are reining in leverage and enforcing the rules on the books now.

 

Robert,

So are you saying firms such as Bright Trading might not have the correct model in the eyes of FINRA?

 

I asked another CEO in the prop trading / professional trading industry to read my above post. He emailed that he did ‘not disagree with my assessment, but thinks it goes deeper’ too.

This CEO mentioned that prop trading can be fine, just like in Wall Street banks - at least until the Volcker Rule may stop that – with one big problematic-difference. Day trading firms continue to take deposits from traders and that more than anything else may resemble a disguised customer account in the eyes of regulators.

FINRA Regulatory Notice 10-18 red-flag list item #6 refers to “firm has evidence of financial transactions or transfers of assets or cash balances that would reasonably evidence separate beneficial-ownership of the sub-accounts.” In my view, that refers to traders making deposits, credited to sub-accounts. Most firms are somewhat cute about keeping the deposits off to the side and not transferring them into the sub-accounts.

The CEO mentioned that “hold backs are okay” in his view. He concluded that FINRA/SEC should better understand the day trading industry and then give better structured guidance.

tOpdOg, sorry but I would prefer to refrain from naming names on prop trading firms in connection with this issue. I am exploring these issues together with other elite trader users in this community-fashion. I don’t have concrete answers and I do not want to cast doubt on any one particular firm. I will continue to make calls and send emails to regulators, CEOs and attorneys to flush out the story more. When I am ready with it all, I will blog it on our site and my Forbes blog too. Even at that point, I expect for different attorneys to have different opinions on the issue and expect the industry will move forward with some adjustments to structure and how they do business with traders. It’s tough to hold traders down!

 

Don,

Can you comment on Robert's posts.

Personally I disagree with it. How can a person who joins a professional trading firm through a registered broker dealer and is a member of an exchange (whether its CBSX, PHLX, or CSE) be remotely considered a "disguised customer account"?

FINRA and The SEC are out to protect the investing public. A person that get fingerprinted, takes the Series 7, and trades professionally all day as their source of income cannot possibly be confused with a guy walking into their corner Ameritrade office and opening an account with $10,000.

I don't think the SEC would waste their time on these firms that are registered as BD's. After all, they all have SRO's that regulate them. Now, if there are complaints filed with the SEC of course they will look into those on a firm by firm basis....but a blanket crackdown on the whole industry seems unlikely.

They will probably continue to crackdown on non registered firms that are not regulated by anyone and seem to be where there have been issues (Worldco, Tuco, Team Trading, etc)

 

Part I

Is FINRA, the SEC and others about to pounce on the day prop trading firm industry?

Over the past decade, regulators prodded the prop trading firm industry to revise prior business models. To move away from engaging prop traders as independent contractors (1099-Misc. non-employee compensation) into wanting prop traders to join the firms as LLC members. We have covered this story on our site (see Proprietary Traders under our Traders tab).

If a person was going to trade the firm’s capital – “prop trading” – they should either be an employee (as in Wall Street banks and brokerage houses) or as an owner of the firm. Regulators tried to clean up the low-hanging fruit, preferring licensed brokers to join prop trading firms organized as broker dealers. Many are “non-customer” broker dealers and they don’t do much if any business at all with “retail” customer accounts. Customers may get up to 4:1 margin as pattern day traders per Reg T margin rules. Prop traders are only limited within the firm itself and many get 10:1 or far greater leverage too – that’s the attraction to prop trading.

One major bone of contention from the start and continuing to this day is the issue of traders being asked to pay deposits to the trading firm. Employee prop traders rarely pay deposits on Wall Street, and a little more often in prop trading firms. Independent contractor and LLC member prop traders usually are requested to pay deposits. The deposit size has a direct (although somewhat hidden) connection to how much leverage they are afforded by the firm and how much their share of trading profits will be (60 to 100 percent depending on deposit size).

In prop trading firms, trader’s deposits are rarely treated as LLC member capital contributions, they are connected to a sub-account’s trading performance and used to cover sub-account trading losses. If a trader leaves the firm, most agreements can demand they pay back any losses in excess of their deposit accounts.

Another concern of mine is the issue of “special allocations” of sub-account trading profits. How the special allocations are done seems to push the envelope of what the IRS has in mind and allows with special allocations in partnership returns. The employee prop trader on Wall Street may have a sub-account to trade and track performance, and then get a bonus based on performance, maybe 50% compensation (the Wall Street model). That employee does not get what many prop traders get, 100% or 99% of the trading profits. We understand that FINRA may regard 99% or 100% payouts as indicative of a beneficial owner – perhaps a disguised customer account. We hear some firms may need to change to 80/20 splits to keep muster.

While some prop trading firms also offer the employee-model option too – where they pay out 60/40 or 50/50 – most rely on the LLC or contractor model where they pay out over 90 percent. Firms seem to make money on services, or rebates. Aren’t rebates a form of collecting commissions? If so, wouldn’t the broker need to be registered as a commission BD too? More on that sometime soon.

Tax wise, special allocations are allowed in partnership returns, which an LLC files. Special allocations stand up to IRS-scrutiny if they follow the money. I always felt it was odd and ‘pushing the envelope’ for a prop trader to be a Class C or D member, not share in firm-wide profits and losses, not share in his own-generated losses in some cases, and get 100% or 99% of their LLC class profits just on their own sub-trading account. There was no sharing even among other prop traders in the same class. Traders “eat what they kill.” Doesn’t that sound exactly like beneficial owners hunted down in FINRA Regulatory Notice 10-18? See details below.

This entire FINRA notice seems bent on identifying “beneficial owners” hidden in prop trading firm master and sub-account relationships. See the definition of beneficial owner in Wikipedia at http://en.wikipedia.org/wiki/Beneficial_owner. “Beneficial owner is a legal term where specific property rights ("use and title") in equity belong to a person even though legal title of the property belongs to another person. This often relates where the legal title owner has implied trustee duties to the beneficial owner.”

Over this past decade on this story, many have used the term “disguised customer accounts.” Is the mission of FINRA - and we hear through the grapevine the SEC coming soon too – to force retail traders back into a customer account peg, rather than trying to fit them into a prop trading firm peg? That would force those traders back into regular retail compliance including 4:1 pattern day trader rules and more.

 

Part II

Let’s go through the FINRA Notice 10-18’s list together. Much of it seems to focus on asking clearing firms to spot these red flags and then take action. Many clearing firms may not be able to spot these red flags, because prop trading firms structure things in a somewhat deceptive manner. For example, if a prop trading firm has a large brokerage account and many domestic and foreign traders (contractors and LLC members), those details (including trader names) may be hidden from the clearing broker. Sub-accounts may be labeled with non-identifying (by legal name) information like just account numbers.

Red flags list:

1. sub-accounts are separately documented and/or receive separate reports from the firm. Yes. Don’t the firms give haircut or other reports of exact sub-account activity analyzed and given to each prop trader?

2. firm addresses the sub-accounts separately in terms of transaction, tax or other reporting. Yes. Don’t the firms summarize the above reports into year-end tax reporting, including either 1099-Misc, Schedule K-1 or W-2?

3. services provided to the sub-accounts engender separate surveillance and supervision…risk management…. Yes. Don’t the firm’s oversee each trader and compare their risk, gains and losses to deposit amounts, offset losses against deposits, and request deposit replenishment? Again, not always seen by clearing firms.

4. firm has financial arrangements or transactions with the sub-accounts, or separate account terms, that reasonably raise questions….about beneficial owners. Yes. Don’t firms offering traders 100% or 99% pay-outs on trading gains sound like the traders are the beneficial owners. If the firm was truly an owner too, wouldn’t they get a bigger share of the trading gains? Arrangements vary by sub-account and trader too.

5. sub-accounts incur charges for commissions, clearance and similar expenses… Yes. Don’t firms charge traders for various services including education, tools, desk charges, in some cases commissions, or rebates and other services?

6. firm has evidence of financial transactions or transfers of assets or cash balances that would reasonably evidence separate beneficial-ownership of the sub-accounts. Yes. In my view, that refers to traders making deposits, although rarely credited to sub-accounts. Most firms are somewhat cute about keeping the deposits off to the side and not transferring them into the sub-accounts.

7. the firm is aware of or has access to a master account or like agreement that evidences that the sub-accounts have different beneficial owners. Yes. Isn’t the firm’s LLC agreement, listing Class C and D prop traders, this type of document?

8. the firm has evidence that a party maintaining a master/sub account arrangement has interposed sub-accounts that have or are intended to have the effect of hiding the beneficial-ownership interest. Yes, as pointed out above, if the sub-accounts have account numbers without names of the traders, that could deemed a form of hiding I presume.

9. the number of sub-accounts maintained is so numerous as to reasonably raise questions ……about beneficial ownership. Yes, many of these prop trading firms have numerous sub-accounts so this seems a concern too.

10. Items 3,4,5,6,8 and 9 would not apply in the case of a registered IBD or a bona fide IA arrangement described in the Notice. Per my earlier posts, I don’t think a prop trading firm organized as a “non customer” broker dealer (BD) can claim it’s an IBD per this notice, as IBDs have customer accounts. FINRA is telling clearing firms they can rely on the customer IB to have handled compliance on its customers. Even if the BD is registered as a customer-taking BD (and many are not), the prop traders in question are not treated by those firms as customers, so I don’t believe the firms can avail themselves of these exceptions in connection with application of this FINRA regulatory notice. I also don’t think these prop trading firms can claim IA status either, as the traders are active and not passive investors, and the firms are generally not registered investment advisors either.

FINRA is asking clearing firms for a lot of help here and they may not see these red flags. Although, if they have huge accounts with these firms, compliance forces them to understand their client and they know what is happening behind the scenes. To claim ignorance is probably not acceptable either.

If FINRA or the SEC goes into to visit - examine or audit - these prop trading firms, they can easily see these red flag items for themselves. Isn’t that enough to take action and what might that action be? Can prop trading firms restructure their business models to share more with their traders, so the traders are not deemed beneficial owners? Will that pass muster with the regulators? Does FINRA equate beneficial owners with should be customer accounts? How will the IRS react to all of this too? Are there any IRS tax planning opportunities?

Who can traders rely on for information and help here? Prop trading firms in the grips of the regulators may lawyer up and protect themselves. They may disclose what they should and want to disclose and not tell traders everything they should learn on their own. Attorneys representing prop trading firms are expected to handle their client’s needs by law and not serve the public’s interest per see.

We help many prop traders on their tax planning and preparation and consult them on big picture items too. I am a writer and also CEO of our firm, wearing two hats. I just want to flush out this ongoing story – which doesn’t appear to every go away - so people can have more information and analysis to make informed-decisions on their own. In the past, many traders decided to continue prop trading because the leverage and access was attractive and they took pay-outs to retain as little money as possible at risk in the firms. Keep your eyes and ears open on this story again now. Plus it’s always a good idea to consult your own attorney, and not necessarily the attorney representing your prop trading firm. I am not an attorney.