SEC/FINRA Officially Issues Warning on Unregistered Broker Dealers

Part III Update

I just spoke with a CEO of a leading professional trading firm. We agreed that the regulators may be primarily concerned with protecting smaller traders from putting up deposits and losing their money quickly. Perhaps, as a follow up reaction to their enforcement action against Tuco Trading, LLC.

This CEO said that most BD prop trading firms have given up taking deposits post-Tuco and they pay out 80% or less, not more. He felt these were the two biggest bones of contention by the regulators. He said that smart firms insist (through affidavit) that customer accounts, who may themselves be sub-LLC prop trading firms, pass down those same terms and conditions with their own prop traders - no deposits and 80% or lower payouts. I think introducing brokers who have customers that are sub-LLC prop trading firms, should go a step further - in the spirit of what FINRA is asking for with their bullet points – and try to ferret out the red flag bullet points with their customers too.

This CEO agreed that whether a registered BD or not, this FINRA 10-18 (or similar SEC notice if it comes down) would apply and the BD could not claim an exemption on non-customers - prop traders not treated as customers. He said to keep in mind that FINRA does not regulate non-customer BDs registered on the CBSX, but the SEC does. Again, we heard the SEC may issue a similar regulatory notice to FINRA 10-18 soon.

Here are three remaining bones of contention in my view, which the CEO disagrees with me about.

Hold backs: Prop trading firms that gave up initial deposits often still “hold back” trading gains for pay-out later on, if not lost first. I wonder if the regulators might consider the hold back a type of deposit, not an initial deposit, but a subsequent deposit. After all, the firm is holding back the trading gains to apply future losses against first, like a deposit.

No aggregation: Prop trading desks on Wall Street do hold back trading gains in a bonus pool for traders. But don’t those bonus pools aggregate the trading desk results and employees share in those bonuses after year-end at bonus time – sharing in each others gains and losses too? They are held back partially for tax reasons and annual bonus payments. My concern about prop trading firms is lack of aggregation in the pay-out model. That prop traders ‘eat what they kill’ and two guys sitting next to each other don’t share at all.

Transaction costs: If a prop trading firm claims it’s not a customer broker dealer or introducing broker dealer, it should not be earning and collecting brokerage commissions. Many prop trading firms collect transaction-related costs like execution, clearing, ECN fees with mark-ups, rebates and more. Couldn’t some of these payments be deemed a form of commissions, even if paid by the trader rather than the clearing firm or broker?

A popular defense for prop trading firms is ‘how is what we are doing any different from what is being done on Wall Street on prop trading desks?’ ‘How is it not okay for one person or company to put up the money and risk management systems, and engage others to trade that money and then split the profits?’

Comparing yourself to Wall Street now may not curry much favor with regulators, Congress and the public. Prop trading on Wall Street may be significantly changed if the Volcker Rule is enacted as part of Fin Reg, but it may not be too. If Congress is carving prop trading desks out of banks and putting it into its own industry, shouldn’t Congress and regulators also catch up on providing helpful rules of the road. In fact, this may be the reason that regulators are acting at this time.

 

Robert,

Who is the "CEO of a leading professional trading firm"?

Don,

What do you make of all this since isn't he implying that Bright Trading is in violation of many FINRA and SEC rules?

Would love to hear your two cents since most consider you the most knowledgeable person around on prop trading.

 

tOpdOg, please remember what I mentioned earlier, that I am just exploring these issues with you all on this thread. That I am not an authority on regulation and compliance, plus I am not an attorney.

I am trying to flush out this story like a journalist might and speak with various people involved. I want those people to speak with me openly without worrying that I will name names and quote them in the media or on message boards.

I also figure that some CEOs may try to spin me a little too and I don't want to be their spin voice in the media, they can speak for themselves.

This may turn out to be a controversial and explosive topic and it should be handled with care. Thanks for your cooperation here.

 

Dude,

You are a total joke. There is no "controversial and explosive topic" here. You are taking a 3 month old FINRA reminder memo and making it seem like it's a huge story.

You have even admitted that you are not sure how to interpret it and you might be wrong and that most attorneys don't know how to interpret it either. How can this be explosive?

You have even admitted that this doesn't even apply to CBSX firms because they are non-FINRA but your "sources" say a release is coming soon.

I'm sure Goldman Sachs (Bright's clearing firm) has seen seen the FINRA memo and Bright is still trading. Merrill Lynch (Echo's clearing firm) has seen the memo and Echo is still trading. Keep in mind this was just a memo, a reminder to clearing firms of a rules that were already on the books. There are no new rules and regulations here. I'm sure the memo was put out as a reminder that non BD's shouldn't have sub accounts.

Can you name one broker dealer that has been contacted by FINRA? Can you name one broker dealer that has been questioned by the SEC about proprietary trading? If you have a legitimate story, speak up....don't hide behind "sources".

For someone that says "I am not an authority on regulation and compliance, plus I am not an attorney"...you certainly are trying to act like one and create a story. If you are a journalist like you claim you are then your job is to report the news, not create it.

You have a tax service for traders. I don't know how coming out of the woodwork and screaming "the sky is falling" benefits you, but I'm sure at the end of the day you will try to get some business out of your scare tactics.

 

When will the SEC figure out what to do with unregistered prop trading firms? It has been what 3 years now? this is getting insane. And are they going to close the CBOE loophole? Can't find a decent place to trade at without worrying about the SEC shutting them down.

GOOD GRIEF!

 

gr8tr8r, your comments are fair and I may be overreacting. I hope my concerns will not be borne out. No one likes to ring a fire alarm bell without a fire.

I was re-prompted on this story last week by a nervous industry-CEO, who probably knows more than most of us do. One industry-attorney that I spoke with today seems to agree with your position. That registered prop trading firm BDs - with any of the exchanges that allow that type of registration - are probably still okay in regard to this FINRA notice. He did agree with me that they can't claim exemption from this notice as a IBD per the notice. He poirnted out the general consensus, that regulators are probably more concerned with non-registered prop trading firms, not organized as BDs.

No one that I have spoken with to date is giving me news about any potentially-new SEC notices. The CEO I spoke with said he expects to see it soon, but he will not tell me more, even though I keep asking. Some large prop trading firms are concerned with this FINRA posture and they previously revised their business models to drop deposits and reduce pay-out percentages to under 80% or less (confirmed by another CEO).

Everyone I spoke with agrees that the SEC should act and if and when they do it will carry huge weight (they have regulatory oversight over all these exchanges). People want bright-line tests and guidance.

Congress is considering stripping prop trading from commercial banks (Volcker Rule) and they may be assessing the regulatory oversight status in the prop trading firm industry - to catch that business.

Bottom line. FINRA is asking clearing firms to spot beneficial owners in master accounts and I think their red flag list applies to registered prop trading firms and there are beneficial owners in those accounts in some firms, but not others.

Yes, this story line is not news yet, because the SEC has not acted yet. We can all wait and see if the SEC acts and read the news afterwards. Some may want to consider the implications of these potential developments beforehand, others may not.

 

Here is my blog from last night. Edited version of prior posts here. Tell me where you think my thinking is wrong, besides the complaint about me ringing the fire bell early in your view. We are discussing this on today's conference call and podcast too. Thanks.

FINRA's notice to prop traders

June 22, 2010

Are FINRA, the SEC and others about to pounce on day prop trading firms?

In April, FINRA’s released its Regulatory Notice 10-18, which includes guidance on master and sub-account arrangements. This document has prompted much debate since its release.

Over the past decade, regulators prodded the prop-trading industry to move away from engaging prop traders as independent contractors. Instead, prop traders were asked to join the firms as LLC members.

A person trading a firm’s capital should either be an employee (as in Wall Street banks and brokerage houses) or 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 meaning they don’t any business with retail customer accounts. Customers can have up to 4:1 margin as pattern day traders per Reg T margin rules. Prop traders are only limited within the firm, so many can have 10:1 or greater leverage, making prop trading quite attractive.

One major bone of contention is the issue of deposits. Employee prop traders rarely pay deposits on Wall Street, and only pay them occasionally 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, these deposits are rarely treated as LLC member capital contributions, and they’re connected to a sub-account’s trading performance and used to cover sub-account trading losses. When traders leave a firm, most agreements demand they pay back losses in excess of their deposit accounts.

Another concern is the issue of “special allocations” of sub-account trading profits. Special allocations seem to push the envelope of what the IRS allows in partnership returns. The Wall Street employee prop trader may have a sub-account to trade and track performance, and then receive a bonus based on performance — perhaps 50 percent compensation (the Wall Street model), whereas many prop traders automatically receive 99 or 100 percent of the trading profits. We understand FINRA may regard the latter payouts as indicative of a beneficial owner — perhaps a disguised customer account. Some firms may need to change to 80/20 splits to keep muster.

While some prop trading firms offer the employee-model option with 60/40 or 50/50 payouts, some still rely on the LLC or contractor model, paying out more than 80 percent. Firms seem to make money on services, or rebates. In my opinion, rebates are a form of collecting commissions, and if this is the case, the broker should be registered as a commission broker dealer.

The IRS allows special allocations in partnership returns, which an LLC files. Special allocations stand up to IRS scrutiny if they follow the money. It’s odd to me that prop traders who are Class C or D members, yet don’t share in firm-wide profits and losses and even their own losses, can still receive 99 or 100 percent of their LLC class profits on their own sub-trading account. Traders eat what they kill.

The FINRA notice seems bent on identifying “beneficial owners” hidden in prop trading firm master and sub-account relationships. 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.” Are FINRA and the SEC looking to force retail traders back into a customer account peg instead of a prop trading firm peg? If so, those traders would be forced back into regular retail compliance including 4:1 pattern day trader rules and more.

The FINRA notice list asks clearing firms to spot these red flags and then take action. Many clearing firms may not be able to see 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, 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.

Here, I’ve included the the FINRA Notice 10-18 list in bold, and my comments thereafter. The notice states a firm will be on inquiry notice if:

1. Sub-accounts are separately documented and/or receive separate reports from the firm. Firms document exact sub-account activity in reports often given to each prop trader.

2. Firm addresses the sub-accounts separately in terms of transaction, tax or other reporting. Firms summarize these 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. Firms often oversee each trader and compare their risk, gains and losses to deposit amounts, offset losses against deposits, and request deposit replenishment. This isn’t 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. Traders receiving 99 or 100 percent payouts on trading gains seem like beneficial owners. If the firm was truly an owner too, wouldn’t it receive a bigger share of the trading gains? Arrangements vary by sub-account and trader.

5. Sub-accounts incur charges for commissions, clearance and similar expenses. Yes. Firms charge traders for various services including education, tools, desk charges, commissions (in some cases), 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. In my view, that refers to traders making deposits, although they are 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. The firm’s LLC agreement, listing Class C and D prop traders is this type of document, in my view.

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. If the sub-accounts have account numbers without names of the traders, that could be 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. Many prop trading firms have numerous sub-accounts, so this is 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. In my opinion, a prop trading firm organized as a non-customer broker dealer (BD) can’t 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 broker dealer is registered as a customer BD, the prop traders in question aren’t 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 believe these prop trading firms can’t claim IA status either, as the traders are active and not passive investors, and the firms generally aren’t registered investment advisors.

FINRA is asking clearing firms for 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 know what’s happening behind the scenes. To claim ignorance is probably not acceptable either.

If FINRA and/or the SEC examines these prop trading firms, they can easily see these red-flag items. What action will they take from there? Can prop trading firms restructure their business models to share more with their traders, so the traders aren’t deemed beneficial owners? Will that please the regulators? Does FINRA equate beneficial owners with “should be” customer accounts? It will be interesting to see how the IRS will react, too.

Prop trading firms in the grips of the regulators may consult their lawyers for protection. They may disclose their pertinent information and not tell traders everything they should learn on their own. Attorneys representing prop trading firms are expected to handle their clients’ needs by law and not necessarily serve the public’s interest. It’s always a good idea to consult your own attorney, and not necessarily the attorney representing your prop trading firm.

We help many prop traders on their tax planning and preparation and consult with them on big picture items too. In the past, many traders decided to continue prop trading because the leverage and access was attractive and they took payouts to retain as little money as possible at risk in the firms. Keep your eyes and ears open on this story.

 

Thank you, Robert. I appreciate the information you have provided and the time it took to form these inferences with your ear to the ground.

 

Robert Green has been writing messages warning about impending doom in the prop industry for six yrs now. Apparently scare tactics are a good way to recruit business. Mabey if Mr. Green spent more time working on his clients taxes he wouldnt have to constantly drum up new business with his the sky is falling rants. Hes also been talking about how traders got hurt by Worldco since they closed their doors seven yrs ago. Well the fact is that everybody eventually got paid all their money back from Worldco. Every penny.

 

I agree 100%....this guy is a total tool trolling for business. Tries to sounds like he knows what he is talking about by posting 5 long posts reposting an old finra memo but then says that he's no authority on the subject and may be wrong. What's up with that?

Go troll for business somewhere else.