Chapter 13 - Trading Desk Supervision PDF

Trading Desk Supervision 13 CONTENT AREAS Overview of Trading Desk Supervision Securities Legislation Supervision of Trading Specific Considerations in Trading Supervision and Compliance LE...

Trading Desk Supervision 13 CONTENT AREAS Overview of Trading Desk Supervision Securities Legislation Supervision of Trading Specific Considerations in Trading Supervision and Compliance LEARNING OBJECTIVES 1 | Explain the core policy objectives and issues reflected in the securities regulatory framework. 2 | Discuss the rules and regulations governing trading activities. 3 | Relate the relevant regulatory requirements to supervision of different types of trading activities. 4 | Identify the major compliance issues, requirements, controls, and tools to be incorporated in a trading supervision and compliance monitoring system that is tailored to a firm’s particular business mix. © CANADIAN SECURITIES INSTITUTE  CHAPTER 13      TRADING DESK SUPERVISION 13 3 INTRODUCTION In the previous chapter, we discussed the importance of carrying out proper procedures related to registration in regard to both the dealer member and employees applying to work as registrants for a dealer member. We noted that the chief compliance officer’s knowledge of registration requirements facilitates an understanding of the types of issues that can arise out of compliance failure. Another area of regulation that affects CCOs in carrying out their compliance responsibilities is trading desk supervision. Trading in securities remains a core activity for most investment dealers and affects most functional areas within a dealer member. Many supervisory and compliance considerations flow from trading activities. Relevant trading rules and related compliance considerations vary dramatically among firms, depending on their particular business models, activities, and the products that they offer. Even within a particular dealer, it may be necessary to have separate but interwoven supervisory and compliance processes, in relation to different trading activities and business units. In this chapter, we explore trading desk supervision in the context of two fundamental policy objectives: protecting investors from unfair, improper, and fraudulent practices; and fostering fair and efficient capital markets, and confidence in their integrity. OVERVIEW OF TRADING DESK SUPERVISION 1 | Explain the core policy objectives and issues reflected in the securities regulatory framework. The basic function of securities trading is to act as either principal or agent in facilitating the matching of a buyer and a seller of a security. This role can be traced back to the origins of the brokerage industry. However, technology, globalization, capital markets growth, new marketplaces, product innovation, and other factors have fundamentally transformed securities markets and trading activities and continue to do so. These changes have been accompanied by a rapidly evolving and increasingly complex regulatory environment, reflected by the enactment of extensive rules by CIRO. Diverse public policy objectives converge in shaping the rules and regulations that govern trading. Nevertheless, there seems to be little doubt that a pervasive common thread originates with the abusive trading activities that are perpetrated by a small minority of brokerage industry participants. Although most securities transactions are conducted for legitimate purposes, illegitimate activities have long been associated with fringe aspects of the industry. Activities that continue to be a focus of regulatory attention include “pump and dump” schemes, boiler room operations, market manipulation, and illegal insider trading, among others. Compliance requirements applicable to trading are usually associated with the specific rules and regulations that affect trade desk activities. However, securities legislation’s broad definition of trade captures virtually all activity related to the buying and selling of securities. Regardless of a dealer member’s business mix, trading must feature prominently in its compliance program. For example, an introducing broker involved only in retail activities might have minimal need for trade desk compliance oversight, if any. This is because the relevant processes may reside with the carrying broker. Some regulatory principles and compliance issues relating to trading apply to almost all firms. For example, mutual fund trading was commonly viewed as a low-risk activity until 2004. In that year, nearly $240 million in penalties were imposed on various fund managers and dealers because of abusive mutual fund trading, which inappropriately benefited short-term investors to the detriment of long-term investors. A CCO must design a compliance system that satisfies complex regulatory requirements and provides assurance against illegitimate activities in a dynamic environment where new compliance risks are continually presented. The myriad of highly complex rules and regulations continue to expand, as do the highly sophisticated market © CANADIAN SECURITIES INSTITUTE 13 4 CHIEF COMPLIANCE OFFICERS QUALIFYING EXAMINATION      SECTION 4 interactions that they apply to. An astute CCO should also consider the effectiveness of internal trading controls in protecting the dealer member’s capital. Many firms have suffered significant financial losses through the unauthorized actions of a rogue trader, unscrupulous clients who successfully defraud a firm, and counterparties who fail to satisfy their obligations. The volume, speed, and volatility of capital markets interactions often mean that decisions must be made quickly, with little time for a detailed analysis of all relevant rules. Chief compliance officers usually try to incorporate relevant requirements into their firm’s operational procedures and processing systems to the maximum extent possible. By this means, they can reduce the need for manual intervention and judgments, but they cannot eliminate it. FOSTERING FAIR AND EFFICIENT CAPITAL MARKETS AND CONFIDENCE IN THEIR INTEGRITY This objective of trading desk supervision stems from the basis of rules that protect investors. Those rules guard clients from fraud and deal with both real and perceived conflicts of interest, which can arise in interactions between dealer members and their clients. From a compliance perspective, this objective has historically focused on safeguarding clients from the inappropriate actions of firms. However, dealer members are now also expected to act as gatekeepers in protecting the markets from such practices by persons external to the firm. Regulators support this objective by mandating transparency in the securities markets. Transparency relates to the extent that accurate pre- and post-trade data is publicly and readily available, including quotations, transaction prices, volume, and similar information. Record-keeping and reporting requirements that may seem merely administrative are viewed by regulators as fundamental to this flow of information to the markets. The policy objectives are usually applied and modified through technical provisions and exemptions specific to a given transaction. The diverse nature of different markets, products, and means of trading leads to differences in how the principles underlying a dealer member’s policies are defined, interpreted, and applied. As a result, it is imperative that CCOs use a combination of principle-based compliance, technical interpretation, and adherence to the spirit of the law. There are two basic types of securities markets: 1. Dealer market In a dealer market, participating dealer members post bid and offer quotations. This is the basis on which prices are established. All trades are done with a dealer member taking the other side as principal, but client orders are not reflected. 2. Auction market An auction market is a market in which clients and registrants enter buy and sell orders, and where trades are made when a buyer’s bid matches a seller’s offer. In other words, the price that a security trades at is the highest price a buyer is willing to pay and the lowest price a seller is willing to accept. The mechanics of an auction market contribute to the most efficient price discovery. Implications arise for participants in each market depending on the dealer member’s role in a particular trade. By acting as principal in either a dealer or auction market, the dealer member assumes the risks of ownership and must commit its capital to its positions. When the dealer member facilitates a trade as an agent in an auction market, it takes on considerably less risk. © CANADIAN SECURITIES INSTITUTE  CHAPTER 13      TRADING DESK SUPERVISION 13 5 SECURITIES LEGISLATION 2 | Discuss the rules and regulations governing trading activities. Securities regulations that apply to trading affect all aspects of a dealer member’s business, regardless of its business mix. Because of the expansive definition of the term trade, many securities regulations are directed at different aspects of securities trading activities. The relevant rules and considerations may vary, depending on multiple factors, as shown in Table 13.1. Table 13.1 | Factors Affecting Securities Regulation Factor Description Classification of the security Equity, debt, pooled investment vehicle (i.e., mutual fund), derivative, hybrid, or exempt Nature of the offering Initial public offering (IPO), other new issues, continuous distribution, private placement, or other exempt distribution Current status of the security Still in distribution, trading on a secondary market, subject to a trading halt, or cease trade order Where the transaction is to be effected Exchange, other secondary market, over-the-counter, internal cross, or private placement Type of transaction Takeover bid, issuer bid, or normal course issuer bid Type of order Client, pro/non-client, long, short, special terms, solicited, or unsolicited Client-specific attributes Exempt purchaser/accredited investor, institutional client, retail client, issuer, insider, significant shareholder, member of a control block, pro/non-client, or holder of restricted shares Attributes of the party on the other side Common beneficial owner of the trade, if known Relationship of the dealer member to the Underwriter, member of the selling group, principal security and issuer distributor, related party, or connected party Role of the firm in relation to the transaction Principal, agent, managed account, or non-discretionary account Relationship to, and interaction with, other potentially competing or conflicting orders, trades, and market conditions Timing of the order During market hours, at the open, or after hours Clearing and settlement requirements © CANADIAN SECURITIES INSTITUTE 13 6 CHIEF COMPLIANCE OFFICERS QUALIFYING EXAMINATION      SECTION 4 Table 13.1 | Factors Affecting Securities Regulation Factor Description Credit considerations and capital charge implications Audit trail requirements Registration status of the various parties within the firm involved in effecting the trade Geographic location of all parties to the trade Including relevant representatives of the firm and securities regulations of each jurisdiction applicable to any of the above factors Any other rules that should be considered Self-regulatory organization, marketplace or issuer defined Assessing any particular transaction or activity and deciding on a course of action is not a simple task. Decision- making is an iterative process in which the answer to any one question influences decisions regarding other factors. Furthermore, there is often interplay with other general application securities regulations. The CCO must make sure that their dealer member has assessed and incorporated all relevant requirements into the design of its compliance program. Fortunately, most transactions are fairly straightforward and can be processed as standard trades conducted by skilled and knowledgeable individuals. The complexity of regulation means that it is sometimes difficult to find quick answers. Correspondingly, even when time permits an examination of the relevant rules and regulations, no answer is certain. Training, education, early-stage compliance involvement, and application of basic principles can provide guidance. THE CANADIAN INVESTMENT REGULATORY ORGANIZATION CIRO oversees the activities of all CIRO dealer members, including their trading activities. The trading standards and requirements in the CIRO rules apply to all CIRO dealer members, regardless of the type of security being traded or the marketplace that is being traded on. CIRO requires that all investment dealers and their employees observe high standards of ethics and conduct in the transaction of their business. It prohibits business conduct or practice that is unbecoming or detrimental to the public interest, and it requires that the character, reputation, and experience of dealer members and their employees be consistent with high ethical standards. Client business must be handled within the bounds of ethical conduct, consistent with just and equitable principles of trade, and not detrimental to the interests of the securities industry. CIRO’s rules, including UMIR, require securities market participants to take reasonable measures to ensure that their activities, as well as those of their clients, comply with applicable requirements. Dealer members and their employees must act as gatekeepers in protecting the markets from illegitimate activities. They must refrain from engaging in inappropriate market activity and monitor for any potential rule violations by clients. In addition, they must conduct investigations, as appropriate, and report inappropriate activities to CIRO or other applicable securities regulators. OVER-THE-COUNTER TRADING CIRO rules also govern trading in OTC markets, including bond trading. Bond trades with clients are typically made on a principal basis and are traded from a dealer member’s inventory, rather than in a transparent auction market. CIRO rules attempt to address this lack of transparency and historic trade-price information. These rules are discussed in greater detail further on in this chapter. © CANADIAN SECURITIES INSTITUTE  CHAPTER 13      TRADING DESK SUPERVISION 13 7 THE UNIVERSAL MARKET INTEGRITY RULES UMIR provides a standard set of trading rules that apply to trading in equities on all Canadian marketplaces, including exchanges and alternative trading systems (ATS). Both Participants and Access Persons, as defined below, must comply with UMIR: Participants “Participant” refers to registered dealers who are members of an exchange, subscribers of an ATS, users of a QTRS, or other persons who have been granted trading access to a marketplace and who perform the functions of a derivatives market maker. Access Persons “Access Person” refers to persons other than a Participant who have direct trading access to an exchange, ATS, or QTRS through the facilities of a Participant. ALGORITHMIC TRADING Algorithmic trading systems allow traders to automatically enter many orders on one or more marketplaces over a brief time. Dealer members using algorithmic trading systems must have supervisory policies and procedures that are adequate to prevent and detect violations of UMIR and applicable securities regulatory requirements. They must ensure that algorithmic trading systems have been tested prior to being engaged, and they must be able to disengage the systems, should the need arise. The supervisory system must include safeguards that are designed to prevent the entry of unreasonable orders and the execution of unreasonable trades. Despite their potential advantages, multiple new marketplaces have complicated trading markets and increased the need for sophisticated regulation. This need, in turn, has raised the following issues: Application of current market conduct rules Treatment of non-dealer industry participants with direct access to marketplaces Level of transparency appropriate for different types of marketplaces Whether data consolidation is necessary in light of technology developments Role of the trade-through obligation THE CRIMINAL CODE OF CANADA Canada’s Criminal Code addresses the following offences directly related to trading activities: Fraud affecting the public market (Section 380) Market manipulation (Section 382) Prohibited insider trading (Section 382.1) Distributing false prospectuses, statements, or accounts (Section 400) Secret commissions (Section 426) The Criminal Code’s prohibitions are similar, but not identical, to corresponding prohibitions in securities legislation, corporations acts, and the rules of self-regulatory organizations. A risk-based compliance regime should consider the ramifications of Criminal Code violations, which apply across Canada to all securities and marketplaces. We discuss market manipulation and prohibited insider trading in greater detail below. MARKET MANIPULATION Market manipulation is defined under Section 382 as creating a false or misleading appearance of trading activity, liquidity, or market pricing in a security. It carries a maximum penalty of 10 years imprisonment. © CANADIAN SECURITIES INSTITUTE 13 8 CHIEF COMPLIANCE OFFICERS QUALIFYING EXAMINATION      SECTION 4 This offence includes wash trading and matched trading, which, as defined under the Criminal Code, involve a deliberate intent to create an artificial, false, or misleading appearance of the price of or demand for a security. This perception, in turn, creates additional demand and higher prices that a manipulator can sell into. Wash and matched trading should not be confused with legitimate, pre-arranged trades, whereby arms-length traders engage in pre-trade discussions. In such cases, both parties agree on the terms of a transaction involving a change in beneficial ownership before entering their orders into the market. Provided that they comply with relevant rules, traders are permitted to meet each other in the market when conducting trades. In contrast, a pre-arranged trade can be considered a wash trade, and therefore a securities regulatory violation, if it has the effect of creating a misleading appearance of trading, even if it does not meet the Criminal Code test for being intentionally deceptive. This difference illustrates the complexities associated with assessing trading activities. EXAMPLE A trader at a dealer member wants to execute a large block trade. A trader at another firm mutually agrees on the terms of the trade. The trader acting as buyer then posts a bid that is immediately met in the market by the selling trader. This activity is a legitimate trade. However, if a dealer member enters a trade to offset a previously entered trade that was made in error, an auditor may view it as trading with itself, which is considered engaging in a prohibited activity. PROHIBITED INSIDER TRADING Inside information is information that has not been generally disclosed and could reasonably be expected to significantly affect a security’s market price or value. Illegal insider trading involves the use of such information for the purpose of trading in a security, either directly or indirectly, by a person in a defined relationship (often referred to as a special relationship) with the company issuing the security. Persons in defined relationships include those who have inside information for any of the following reasons: They are shareholders of the issuer. They have a business or professional relationship with the issuer. They obtained the information as a party to a proposed merger, takeover, or reorganization of the issuer. They obtained the information in the course of their office, employment, or duties with the issuer or an entity noted above. They received the information from a person who obtained it by virtue of the positions or relationships noted above. The Criminal Code definition of inside information differs from that in securities legislation, but it applies similar, though not identical, standards in the context of undisclosed material information, material facts, and material changes. It is unclear whether the distinction is substantive or semantic. A Criminal Code offence closely related to illegal insider trading is tipping. Tipping occurs when an insider conveys inside information, other than in the necessary course of business, knowing that the recipient may trade on the information or pass it on to others. LEGAL DETERRENTS TO CRIMINAL CODE VIOLATIONS The maximum penalty under the Criminal Code is 10 years imprisonment for insider trading and five years’ imprisonment for tipping. In addition, persons found guilty of insider trading under provincial securities legislation can face jail terms of up to five years and fines of $5 million, or a multiple of the profit made or loss avoided by the illegal trade, whichever is greater. Note that penalties vary by jurisdiction. © CANADIAN SECURITIES INSTITUTE  CHAPTER 13      TRADING DESK SUPERVISION 13 9 Legislation addressing these and other Criminal Code violations has resulted in expanded resources. For example, Integrated Market Enforcement Teams have been established across Canada for the purpose of investigating and prosecuting such offences. These teams comprise Royal Canadian Mounted Police investigators, Department of Justice legal advisors, securities regulators, representatives of other federal enforcement agencies, law enforcement agencies of local jurisdiction, and forensic accountants. Various support staff services have also been established in key financial centres of Canada. Criminal charges arise only in the most egregious situations and where it is possible to meet evidentiary standards under criminal law for intent (or knowledge) and of proof beyond a reasonable doubt. Although these prosecutions are infrequent, the serious nature of the potential consequences of a violation should act as a deterrent. SUPERVISION OF TRADING 3 | Relate the relevant regulatory requirements to supervision of different types of trading activities. In addition to performing trade supervision over investment advisors from a business conduct perspective, dealer members are obliged to supervise the trading activities of registrants at the firm. Specific CIRO rules for trading supervision apply depending on the market and the type of security traded. However, the dealer member’s obligations typically incorporate the following common components: Written policies and procedures reflecting all relevant regulatory requirements Policies addressing conflicts of interest and confidentiality obligations Internal supervisory control and compliance resources to monitor and enforce adherence to policies and procedures Processes to deal with potential and actual violations Proper qualification and training for all relevant employees A distinction between business line supervision and compliance department monitoring Despite the similarities, there are also key differences among the requirements set out in various trading supervision rules. RETAIL VERSUS INSTITUTIONAL TRADING SUPERVISION AND COMPLIANCE Trading supervision and compliance monitoring routines vary considerably between retail and institutional activities. Each side is driven by the nature of its business and the related risks. Institutional client transactions often involve either large amounts or large volume, or both. Institutional products and services are often complex, and there may be few precedents to rely on for guidance. An error in judgment or a compliance failure can have a significant negative impact. Accordingly, a strong culture of compliance driven by business management, including the CCO, is essential. No amount of compliance oversight can rectify a business culture that is not compliance driven. In contrast, many retail trades are for small quantities on a non-discretionary basis. The ability to place discretionary trades is highly restricted. One of the most common regulatory disciplines against retail advisors is for effecting unauthorized discretionary trades, although many clients request or acquiesce to such trades. The typical motivation for unauthorized discretionary trades is client unavailability in conjunction with market movement and timing, rather than best execution. © CANADIAN SECURITIES INSTITUTE 13 10 CHIEF COMPLIANCE OFFICERS QUALIFYING EXAMINATION      SECTION 4 Despite the seeming disparities, there is a fundamental overlap between retail and institutional trade monitoring that emphasizes the key distinction between business line supervision and compliance monitoring. Furthermore, although some rules explicitly distinguish between the two, other regulations, such as UMIR, do not. EXAMPLE The CCO of a retail dealer member that offers only mutual funds must consider the following issues when designing a compliance program: Rules specific to trading in mutual funds Registration requirements relevant to trading on behalf of clients in their province of residence U.S. securities regulations that restrict Canadian dealers and advisors from transacting for persons who temporarily reside in, or have permanently relocated to, the United States Similarly, the CCO of an institutional corporate finance and trading boutique must assess inter-provincial and cross-border issues, although from a different perspective. MINIMUM COMPLIANCE PROCEDURES UMIR Rule 7.1, Trading Supervision Obligations is a fundamental reference point for CCOs and compliance staff of dealer members that trade equities and other securities on Canadian markets subject to UMIR. In part, it sets out the minimum procedures that a trade desk compliance program must follow when trading in such markets. The trade review process varies depending on the nature of the firm and the resources available. Some dealer members have proprietary systems for monitoring and processing trades that also support the review process. Other solutions offered by marketplaces or independent vendors should be evaluated for their suitability to the firm’s business. Although compliance requirements are detailed in UMIR, dealer members must consider how specific processes can apply to securities that may not trade in a public marketplace. GATEKEEPER RESPONSIBILITIES In recent years, the regulatory focus on the responsibilities of dealer members and their employees to act as gatekeepers has increased significantly. This increased scrutiny is particularly evident in revisions to UMIR that clarify specific requirements under Rule 10.16 and Policy 10.16, Gatekeeper Obligations of Directors, Officers and Employees of Participants and Access Persons. Investment dealers must refrain from engaging in abusive activities and must have reasonable controls in place to prevent their employees from doing so. They must also monitor for potential violations by their clients, conduct investigations as appropriate, and report inappropriate activities to CIRO or other applicable securities regulators. Participants must also investigate and report activities that may be a violation of UMIR rules in relation to the following activities: Just and equitable principles of trade Manipulative and deceptive trading Improper orders and trades Front-running Best execution Client priority Trades on a marketplace Any other requirements so designated by CIRO © CANADIAN SECURITIES INSTITUTE  CHAPTER 13      TRADING DESK SUPERVISION 13 11 Dealer members must have a documented policy with a procedure to be followed when an apparent violation is detected. Such reports must be recorded and must include the scope of the investigation and the results. If the investigation reveals a violation, then a report must be filed with CIRO. Furthermore, some potential violations might need to be reported to other bodies, such as a securities commission or, if potential money laundering is involved, FINTRAC. It should be noted that the gatekeeper requirements for Access Persons vary from those for Participants. Access Persons are typically granted unfettered access to the marketplace, but CIRO does not have jurisdiction over them. The Participant, on the other hand, is accountable for the actions of an Access Person through the facilities of the dealer member. For this reason, the Participant must be diligent in monitoring both the trading activities and order entry activities of the Access Person. EXAMPLE Orders entered during the pre-opening phase can affect the displayed calculated opening price. Testing the opening by entering different orders to measure impact can be considered manipulative and deceptive behaviour. Potential violations can also arise regarding conducting business openly and fairly (UMIR Rule 2.1) and manipulative and deceptive trading (UMIR Rule 2.2). EMPLOYEE PERSONAL TRADING CIRO rules require that employees of a dealer member maintain their accounts with their employer. An exception to this rule occurs when the employer has given its permission to the employee to maintain an account elsewhere. Copies of account statements and trade confirmations must be directed to the firm’s compliance department. Many dealer members have policies prohibiting employees from maintaining accounts at other firms because of the cost and difficulty in properly supervising these trades. Illegal insider trading and client priority are important concerns, especially when the firm is involved in capital market distributions or mergers and acquisitions activities. In such cases, employees may be in a position to use previously undisclosed material information in making trades. Other trading issues involve speculation and the use of margin. Employees who have significant trading debts or make large numbers of trades may be at risk of losing sight of their day-to-day responsibilities, which are to serve their clients and their employer. Trading floor staff may also be subject to trading restrictions relating to front-running and client priority. To ease supervision, most dealer members require that employee accounts be maintained in account ranges designated as PRO accounts. Generally, such accounts cannot participate in distributions of securities that the dealer member is involved in. Some dealer members require employees to obtain approval from their manager before entering a trade— sometimes using a specific, preprinted form. The manager likely knows if the employee might have information that could compromise the integrity of the trade. A firm should create separate trading reports for all PRO accounts to ensure that they are reviewed at the head office level. ORDER ENTRY AND TRADING Order entry and trading controls are necessary for issues relating to suitability, credit, potential errors, market manipulation, and insider trading. Electronic order entry systems have made client order entry and trading easier to control; however, the lack of manual review has increased the need for effective management reporting. Dealer members can assert significant control when entering orders. Currently, most orders are entered electronically and require the completion of mandatory fields. Most firms can introduce pre-approval criteria for orders meeting a threshold, and they can customize the criteria for different registrants and different types of trades. For example, greater controls can be placed on novice advisors, and manual overrides can be required for large © CANADIAN SECURITIES INSTITUTE 13 12 CHIEF COMPLIANCE OFFICERS QUALIFYING EXAMINATION      SECTION 4 trades. When a manual override exists, orders should be approved promptly, and backup should be available for approving trades. Trading system controls can also prevent the entry of solicited orders in restricted securities. Dealer members may require pre-approval of trades in particular securities because of issues relating to concentration or excessive trading. Some dealer members permit advisors to place orders directly with trading desks. This practice should be discouraged or prevented because it can lead to problems with time discretion. A frequent control in these circumstances is to require that client account numbers accompany aggregated orders prior to execution by the trading desk. Dealer members should also determine which staff members are permitted to enter orders and whether such staff members are required to be licensed. In some cases, dealer members require any staff member who enters orders to be licensed as an investment representative at minimum. EQUITY SALES AND TRADING DEPARTMENT: COMPLIANCE AND SUPERVISION PROGRAMS CIRO rules, including UMIR, require securities market participants to take reasonable measures to ensure that their activities, as well as those of their clients, comply with applicable requirements. Investment dealers and their employees must act as gatekeepers in protecting the markets from illegitimate activities. They must refrain from engaging in inappropriate market activity and must monitor for potential rule violations by their clients. They must also conduct investigations as appropriate and report inappropriate activities to CIRO or other applicable securities regulators. Regulators do not dictate a trading supervisory model; dealer members can have various models for the supervision of their trading desks. Many trading desks have a variety of trading-related functions, each of which may have its own designated supervisor with oversight and responsibility for the group’s compliance. Many dealer members currently maintain a compliance presence on trading floors and in capital markets. This presence has a dual purpose: 1. Compliance staff can serve as an effective resource for supervisory, trading, and other capital markets staff. 2. A compliance oversight program operating on the trading floor, investment banking, and other areas can benefit from the day-to-day conversations with business staff about business activities. In implementing a supervisory program for a trading desk, supervisors employ two primary methods: observation and reviews: Observation Includes direct and indirect feedback from the traders, salespersons, and their clients. It is carried out in the course of answering questions, approving requests (such as pre- clearing personal trades), directing activities, and listening to conversations. Reviews Are based on exception reports and other reports provided by finance, risk, and compliance departments. These reports include the previous day’s commissions by clients, profit and loss, risk positions, compliance inquiries, and any other management report that summarizes, details, or extracts information about the trading desk’s activities. The supervisor must document his or her reviews and any follow-up. Email records and electronic signatures on reports generally provide sufficient evidence of trading activity reviews. © CANADIAN SECURITIES INSTITUTE  CHAPTER 13      TRADING DESK SUPERVISION 13 13 Supervisors should lead by example. They should also make sure that the trading staff members are sufficiently trained and competent to execute their responsibilities. EXAMPLE Fatima works on the trading desk of a major dealer member. Fatima accepts an order from her client and evaluates the order before entering it into the system to ensure that it complies with all of the dealer member’s relevant rules. However, Fatima has some doubts about the appropriateness of this particular transaction, so she decides to confer with Sabine, her supervisor. Sabine takes time to review the order and reminds Fatima that she should always approach her about any orders for which she has doubts. FIXED INCOME SALES AND TRADING DEPARTMENTS: COMPLIANCE AND SUPERVISION PROGRAMS CIRO rules and guidance notes describe the standards for trading in debt markets. A number of general principles are common across these rules, including dealing fairly with customers, providing fair pricing and valuation, and complying with any reporting requirements. Also common across these rules is maintaining policies and procedures to ensure that the dealer is complying with rules, regulations, and best practices, as well as with Bank of Canada and Department of Finance regulations for treasury auctions. More specifically, a dealer member’s policies and procedures must explicitly address the following items for the debt securities markets: Restrictions of and controls over trading in non-client accounts A prohibition on the use of inside information A prohibition of front-running Standards for fair allocation of new issues among clients Standards for prompt and accurate disclosure to clients and counterparties if any conflict of interest arises For retail client accounts, dealer members must also establish written mark-up, mark-down, and commission procedures or guidelines for retail debt trading activities. They must also supervise these pricing practices to ensure that any deviations from the guidelines are justified. Trade confirmations for non-primary market debt transactions must include either of the following amounts: The total amount of any mark-up or mark-down, commission, or other service charges the dealer member applied to the transaction The total amount of any commission charged to the client by the dealer member and, if the dealer member applied a mark-up or mark-down or any service charge other than a commission, the following notification (or a notification that is substantially similar): “Dealer firm remuneration has been added to the price of this security (in the case of a purchase) or deducted from the price of this security (in the case of a sale). This amount was in addition to any commission this trade confirmation shows was charged to you.” DID YOU KNOW? A dealer member’s policies and procedures must specifically address trading and conduct in the debt securities market to provide reasonable assurance of compliance with securities laws and CIRO requirements. An executive responsible for the appropriate business group of the dealer member must approve these policies and procedures. For complete requirements, visit CIRO’s website. © CANADIAN SECURITIES INSTITUTE 13 14 CHIEF COMPLIANCE OFFICERS QUALIFYING EXAMINATION      SECTION 4 The following prohibited practices must be identified in a fixed income supervision program: 1. Engaging in any trading practices in the domestic debt market that are fraudulent, deceptive, or manipulative, such as: Executing trades primarily intended to artificially increase trading volumes; Executing trades primarily intended to artificially increase or decrease trading prices; Spreading or assisting in the spreading of any rumours or information regarding issuers that a dealer member knows or believes, or reasonably ought to know or believe, are false or misleading; Disseminating any information that falsely states or implies governmental approval of any institution or trading; or Conspiring or colluding with another market participant to manipulate or unfairly deal in the domestic debt market. 2. Engaging in any trading that takes unfair advantage of customers, counterparties, or material non-public information, such as: Acting on specific knowledge of a new issue or client order in such a way as to unfairly profit from the expected subsequent market movement and/or distort market levels; Executing proprietary trades ahead of client orders on the same side of the market without first disclosing to the client the intention to do so and obtaining his or her approval; Using proprietary information, the release of which could reasonably be expected to affect market prices, to profit unfairly; Using material non-public information that may reasonably be expected to affect prices in the domestic debt market for gain; Abusing market procedures or conventions to obtain an unfair advantage over, or to unfairly prejudice, its counterparties or customers; or Consummating a trade where the price is clearly outside the context of the prevailing market and has been proposed or agreed to as a result of manifest error. DID YOU KNOW? All dealer members must report detailed information regarding each of their debt securities transactions to CIRO through its Market Trade Reporting System. The reported data aids CIRO in performing surveillance to identify the following potential market abuses and violations, among others: Violations of fair pricing requirements Illegal insider trading Market manipulation Overall, the trade data enables CIRO to provide proper oversight to ensure the integrity of the OTC debt securities market and to strengthen the standards of investor protection. © CANADIAN SECURITIES INSTITUTE  CHAPTER 13      TRADING DESK SUPERVISION 13 15 SPECIFIC CONSIDERATIONS IN TRADING SUPERVISION AND COMPLIANCE 4 | Identify the major compliance issues, requirements, controls, and tools to be incorporated in a trading supervision and compliance monitoring system that is tailored to a firm’s particular business mix. As discussed above, regulators have set out their trading requirements in different ways and at different levels. General securities regulatory and CIRO standards apply to all activities of each dealer member. Those requirements are augmented by the UMIR standards for trading in listed Canadian equities and by specific CIRO rules for trading in the domestic debt markets. All these rules have the same spirit and intent, with unique elements depending on the market in question. All dealer member activities must be assessed against the rules applicable to the security and to the marketplace. The following discussion is focused on aspects of public market and OTC trading that may not always be relevant to securities that are structured or transacted in a way that reduces the possibility of abusive activities. For example, the order processing and valuation mechanisms associated with securities such as mutual funds and exchange-traded funds result in their being less susceptible to secondary market trading concerns than an equity security. By extension, a widely held and highly liquid equity security that publicly trades on an internationally recognized exchange generally does not pose the same degree of risk as a small- capitalization, thinly traded equity that trades on a loosely regulated market such as the Over-the-Counter- Bulletin Board or Pink Sheets in the United States. MULTIPLE MARKETPLACES In 2001, NI 21-101, Marketplace Operation and NI 23-101, Trading Rules were adopted by CSA. Known together as the ATS Rules, they were designed with the following objectives: To facilitate competition and investor choice To identify and implement the requirements that improve market integrity given multiple marketplaces trading the same securities To minimize the impact of any fragmentation caused by competition through transparency and other requirements The ATS Rules provide a structure for the regulation of marketplaces and a framework for ATSs to compete with exchanges. The rules require each marketplace to provide fair access by not unreasonably prohibiting or limiting access to its services. They also impose certain transparency requirements on marketplaces; however, they do permit ATSs to operate as dark pools, in which orders entered are not publicly displayed. The ATS Rules also include prohibitions against manipulative and fraudulent activities, as well as provisions that apply to dealers and advisers relating to best execution. The ATS Rules were revised in 2011 to include requirements for the Order Protection Rule (OPR). The OPR requires that all immediately accessible, visible, better-priced limit orders are executed before inferior-priced limit orders and are not traded through. This rule is intended to promote fairness in the market and maintain investor confidence by rewarding investors that contribute to the price discovery process. The implementation of OPR transferred the obligation to establish policies and procedures to prevent trade-throughs to marketplaces; however, marketplace participants may enter directed-action orders (DAOs) for which marketplaces do not have trade-through prevention obligations. Marketplace participants entering DAOs have a responsibility to employ policies and procedures to prevent trade-throughs from occurring. © CANADIAN SECURITIES INSTITUTE 13 16 CHIEF COMPLIANCE OFFICERS QUALIFYING EXAMINATION      SECTION 4 Best execution requirements state that “a Participant shall diligently pursue the execution of each client order on the most advantageous execution terms reasonably available under the circumstances.” As such, Smart Order Routers (SORs) have become a requirement of all dealers. A SOR is a system that automatically assesses multiple marketplaces (exchanges and ATSs) and distributes orders to the marketplace where it can obtain the highest- quality execution available. ABUSIVE TRADING AND JUST AND EQUITABLE PRINCIPLES OF TRADE In general, business must be conducted openly, fairly, and in accordance with just and equitable principles of trade. The term “just and equitable principles of trade” can have broad application, but in essence, it tends to operate as a general anti-avoidance provision. UMIR Rule 2.1 provides that market participants who intentionally organize their business and affairs to circumvent the application of a rule may be considered to have engaged in conduct that is contrary to just and equitable principles of trade. EXAMPLE An example that is contrary to just and equitable principles of trade is the act of avoiding an obligation to enter an order on a marketplace by having another person makes a trade off of a marketplace, in circumstances where a valid off-market exemption is not available. In other words, a dealer member should not artificially arrange that a trade be conducted by a foreign affiliate simply for the purpose of avoiding an obligation to effect the trade on a Canadian marketplace. The UMIR standard also effectively bans activities that may affect the marketplace, but do not reach the level of manipulative and deceptive trading. EXAMPLE The following activities might be construed to be in violation of just and equitable principles of trade under UMIR Rule 2.1: A trader repeatedly takes advantage of having prior knowledge of various expressions of interest for the purpose of trading in a particular security. Actions that violate the principles may fall between those of a trader who acts despite being aware of a single, uncertain expression of interest, and those of a trader who acts with certain knowledge of a client order and is intentionally trading ahead. A trader enters client and principal orders without the client’s consent, and in such a way as to attempt to obtain execution of a principal order in priority to the client order. This action effectively overlaps with separate client priority rules. Traders must also not effect a trade, or a cross, that will move the market in a security by more than the specified price thresholds in the course of a single trading day. This means that the trade, or cross, should not be executed at a price that is outside the current bid and ask range. UMIR Rule 2.1 provides that this activity constitutes abusive trading contrary to just and equitable principles of trade. Participants must notify CIRO in advance of such trades, obtain approval, and move the market in an orderly manner over a period specified in UMIR and directed by CIRO. The broad nature of these standards means that they can be difficult to apply in practice. Although specific examples of conduct violations are available, CCOs should assess particular situations using a principle-based approach. They should approach with caution cases where the technical requirements of another trading rule are complied with, but the contemplated activity seems to be contrary to the intent of the rule. Such activities may be deemed to be not in accordance with just and equitable principles of trade. © CANADIAN SECURITIES INSTITUTE  CHAPTER 13      TRADING DESK SUPERVISION 13 17 MANIPULATIVE OR DECEPTIVE TRADING One of the most serious trading violations is engaging in manipulative or deceptive trading. According to UMIR Rule 2.2, any market activity that is created and that is not the result of the entry of bona fide orders may be interpreted as manipulative and deceptive. Both the creation of transactions and the entry of orders into a marketplace may be viewed as such. Parallel standards are reflected in CIRO rules. A firm might engage in manipulative or deceptive practices for either of the following reasons: To create an illusion of activity in a security and thus generate outside interest or attract order flow to a market participant To create a false closing price to enhance a stock or portfolio valuation, or to deceive other market participants and manipulate the opening market price When testing for manipulative or deceptive trading, compliance officers should look for evidence of the following activities: Fictitious trades A fictitious trade is any regular or excessive activity among a limited number of accounts, especially at a common price. Wash trading Wash trading involves the creation of trades in which there is no change in beneficial or economic ownership. Particular attention should be paid to transactions that take place between a dealer member’s inventory accounts. This can occur intentionally (when traders trade with themselves to remove an order from a book) or unintentionally (when two unrelated business units “bump into each other”). Although regulators have in some cases tolerated unintentional wash trading, the CCO should implement controls to identify and address these actions. Matched trading Matched trading is a variation on wash trading, whereby one person enters an order for the purchase of a security knowing that an offsetting opposite order of substantially the same size, price, and time is being placed by a different person. Cornering the market Cornering the market involves trades made with the intent of limiting the supply of a security to the extent that the settlement of trades may be affected. This activity can create artificial demand in the marketplace, which impacts price and trading activity. False or misleading This practice includes activities such as the setting up of trades or entering buy or appearance of trading sell orders to give the impression of a successive trade, or entering orders in the pre- activity opening period to test the effect of orders on the calculated opening price on a public marketplace. Some terms used to describe orders entered without an intention to trade include what is known as stacking the bid. Essentially, an order to purchase securities should never be entered without a reasonable expectation of payment, nor should a sell order be entered without the reasonable expectation of settlement. Artificial pricing Artificial pricing is typically associated with the final sale price of a security that creates a closing sale at an artificially high or low price not derived from natural trading. Traditionally, testing for this type of activity was done at calendar year-end, calendar quarter, and month end. Increasingly, however, regulators are demanding that testing be conducted over random periods. Testing must include the entry of orders that create an artificial bid or offer price. These types of orders are usually entered in the final moments of the trading session, but they may be entered earlier in the trading day on very illiquid securities. © CANADIAN SECURITIES INSTITUTE 13 18 CHIEF COMPLIANCE OFFICERS QUALIFYING EXAMINATION      SECTION 4 Double printing Double printing is typically deemed to have occurred when two trades are made in the marketplace and only one is required to complete an order. The most common occurrence is when a trader who is on the phone with a client buys or sells a block of securities (from or to the client) with the firm’s inventory on the contra side. The trader then trades with the marketplace to flatten the inventory position. In this case, regulators believe that because the client order could have been satisfied by the natural liquidity of the market, twice the necessary volume of stock was traded. However, it is not double printing if the trader flattens a position from a client over more than one marketplace. In that case, the trader has accepted some risk in completing the client order, whereas double printing involves no risk. The rules addressing trades that involve no change in economic or beneficial ownership are essentially the inverse of the rules prohibiting off-marketplace transactions (discussed below). All employees should know the rules and regulatory guidelines addressing these types of trades. Technical requirements apply to related party trades and trades done without consideration (such as gifts and charitable donations) and should be carefully assessed. IMPROPER ORDERS AND TRADES UMIR Rule 2.3 prohibits the entry of an order or execution of a trade where it is known, or ought reasonably to be known, that doing so would not comply with (or would result in the violation of) any applicable securities legislation, self-regulatory organization rule, requirement of the marketplace or any other provision of UMIR. SHORT SELLING Short sales are sales of a security that the seller does not own. They may be speculative trades by investors who believe that the price of the security is about to fall. Short selling may also be part of a hedging strategy by investors who have an offsetting long position, hold convertible securities, or are engaging in a covered hedge trading strategy. Regardless of the motivation, the short seller must borrow the securities to effect the sale, with the expectation of reacquiring the securities later, at a lower price, and returning them to the lender. Short sales are governed by technical rules, including determination of whether a sale is short or being made from a long position, accurate order marking, margin requirements, and periodic regulatory reporting of current short positions. The CCO of a dealer member should make sure that the firm’s compliance policies and procedures address certain regulatory requirements in relation to short sales. The CCO should ascertain whether a client is long a security prior to accepting a short sale order and, when placing an order, clients must advise their agent if they are selling short per Section 48 of the Securities Act (Ontario). Many considerations apply when assessing a client’s confirmation. EXAMPLE 1. The seller of a security recently purchased the security, and the settlement of that transaction will occur before the settlement of the intended short sale. The seller is deemed to own the security and the sale is therefore not considered short. 2. The seller of a given security owns another security that is convertible into the security sold short. The convertible security was submitted with irrevocable instructions for conversion, and the conversion will be complete before the settlement of the transaction involving the security sold. Again, the sale is not considered short. © CANADIAN SECURITIES INSTITUTE  CHAPTER 13      TRADING DESK SUPERVISION 13 19 Accurate order marking of short sales must be identified as such at the time of order entry to ensure that traders comply with the short sale rules. It must be clearly indicated on the order that the order is a short order. However, an exception can occur when the order is from an account for which purchase and sell orders are designated as short-marking exempt. The order of an account that qualifies for this designation should also not carry the short sale designation (see UMIR 6.2). Policies and procedures are required by regulation to result in the reporting of short positions. For example, UMIR Rule 10.10 requires firms to calculate, as of the 15th and last day of each calendar month, the aggregate short position of each individual account in respect of each listed security and quoted security. These calculations must be filed with CIRO not more than two trading days after the calculation is made. A further illustration of the complexities associated with short selling is provided in IIROC Notice 16-0029 The notice states that a person who holds an option, and intends to pay the exercise price of the option from the proceeds of the sale of the securities that will be issued on the exercise of the option, must designate the sell order “short”. The reason for this provision is that the holder of the option has not done everything required to exercise it at the time of the proposed sale, including paying the exercise price. As a result, a seemingly cashless options exercise from a long position requires categorization, order marking, margin, and account documentation for a short sale. SHORT BUNDLING Short bundling is the practice of combining a regular sale from a long position with a short sale when an order is entered. According to CIRO, bundling is not encouraged. It would be appropriate to designate the entire order as a short sale upon entry to a marketplace. NAKED SHORT SALES In a naked short sale, the seller does not borrow or arrange to borrow the securities in time to make delivery to the buyer by settlement date. As a result, the seller fails to deliver securities to the buyer when delivery is due, which is known as a failure to deliver (or fail). Potentially abusive market activity through the use of naked short sales to drive down the price of a stock is a source of regulatory concern. This practice prompted some of the measures implemented by SEC in the U.S. through its Regulation SHO. REGULATION SHO Regulation SHO provides the following specific requirements for short selling in U.S. securities: Before the execution of a short sale, arrangements must be made to borrow or otherwise acquire the securities to ensure delivery on settlement date. This requirement is waived for market-making activities. Each market centre (New York Stock Exchange and NASDAQ) must publish on each settlement day a list of securities that have been failing to the CNS System operated by the National Securities Clearing Corporation for a minimum amount over a defined period. These securities are known as threshold securities. A broker-dealer who is failing for 13 consecutive settlement days in a threshold security close-out must deliver the position by buying the securities in the market. If the broker-dealer cannot buy in to the securities (because there are no offers in the name), the broker-dealer, and any broker for which it clears, is prohibited from accepting any additional short sale orders in that security until the fail is cleaned up, unless it first borrows (or contracts to borrow) the security. Dealer members that trade directly or indirectly on SEC-regulated markets that they should adjust their trading practices to comply with this rule. FRONT-RUNNING Front-running is a prohibited activity in which an industry participant has knowledge of a client order that can reasonably be expected to affect the market price of a security. The participant inappropriately trades ahead, or © CANADIAN SECURITIES INSTITUTE 13 20 CHIEF COMPLIANCE OFFICERS QUALIFYING EXAMINATION      SECTION 4 otherwise uses knowledge of the order to benefit a third party, in advance of entering the client order. The relevant requirements aim to prevent market participants from illicitly benefiting from confidential information about client activities. For front-running to occur, the participant must have both specific knowledge of a client order and a reasonable expectation that the order could affect the market price of the relevant security or a related security. Prohibited activities in such circumstances generally extend to any of the following activities in advance of entering a client order: Entering a principal or non-client order for the security or any related security Soliciting a trade in the security or any related security from another person Informing any other person, other than in the necessary course of business, of the client’s order Rules prohibiting front-running encompass trading in other markets and related securities, including derivatives, such as options and futures. Front-running prohibitions address situations in which the client’s order is either pending or intentionally delayed, so that the participant benefits to the disadvantage of the client. Trading based on rumours or other non-specific market information does not typically constitute front-running. Specifically, if there is a rumour of a pending order but a trader does not have that order in hand, any trading of the security will not normally be deemed inappropriate. Front-running should not be confused with insider trading. While the two are not mutually exclusive, having knowledge of a client trade about to be entered in the market does not typically make that person an insider. Some rules addressing front-running may on their surface seem straightforward, but they entail numerous areas of technical and practical complexity. For example, UMIR Rule 4.1 contains exceptions to the general rule in relation to the markets regulated by CIRO, including trades in relation to hedges, arbitrage, and pre-existing, legally binding obligations. These provisions address situations in which the dealer member would have traded in a particular manner regardless of the client’s order. Another issue involves determining when individual knowledge is deemed to be organizational knowledge. For example, UMIR Rule 10.4 extends the rules prohibiting front-running to include trading by related entities of the dealer member. The prohibition extends to the firm that accepts the order and its employees, and also a competing firm with advance knowledge of the order and its employees. Many dealer members use information barriers to comply with front-running regulations. For example, a firm that conducts both proprietary and agency trading may segregate these trading desks and restrict information flow between them. Firms may also decide to segregate institutional and retail trading functions, thereby creating an environment where one group has no knowledge of the other’s orders and neither group is unduly restricted in its trading. However, such structures must be designed in accordance with regulatory requirements, which may artificially impute knowledge across an organization, even when effective information barriers exist. Another supervisory and compliance surveillance technique involves monitoring trades made by relevant clients and personnel in the same, or related, securities within a pre-established period. For example, the minimum trade desk compliance procedures under UMIR Rule 7.1 require a periodic review of a sample of proprietary and employee trades prior to large client orders and transactions that will affect the market. Similarly, the daily trade and monthly account review procedures for retail accounts under CIRO rules should address front-running. It is important to assess whether a trade was likely to affect the market. A PRO trader entering a small quantity order in a widely traded and highly liquid security at approximately the same time as a client may be addressed by the client priority rule (discussed below). The PRO must also make the appropriate trade declarations, which address potential conflicts when orders are entered at the same time. In this case, it is unlikely that either trade will impact the market. A similar pattern of trading in a thinly traded security may warrant more scrutiny over the timing of the PRO trade in relation to the client trade. © CANADIAN SECURITIES INSTITUTE  CHAPTER 13      TRADING DESK SUPERVISION 13 21 BEST EXECUTION Best execution includes the many facets of trading expertise and finesse brought to bear by an executing firm in order to best meet the objectives of its client in the context of a particular trade. Those employees who deal with client orders must often use professional judgment and experience to determine the best course of action for a client. This obligation ranges from protecting against predatory behaviour by other market participants to achieving economies of scale. Best execution is defined in the ATS Rules as the most advantageous execution terms reasonably available under the circumstances. Under the ATS Rules, dealers and advisers must make reasonable efforts to achieve best execution when acting for a client. The concept of best execution takes into account a number of aspects of a trade and is not limited to price. There is no simple, purely objective definition of best execution and, often, many factors may be relevant in assessing what constitutes best execution in any particular circumstance. Although best execution has often been equated with achieving the best price, the best execution obligation should be viewed as separate and distinct from obligations related to better-priced orders. Best execution has also been described as a process, rather than an outcome for each trade. The CSA has suggested the following commonly agreed on key elements of best execution: Price Speed of execution Certainty of execution Total transaction cost CIRO rules provide that a dealer member must establish, maintain and ensure compliance with written policies and procedures that are reasonably designed to achieve best execution when acting for a client. The rules also state that the dealer’s best execution policies and procedures must identify factors used to achieve best execution when manually handling a client order for a listed security, including the following prevailing market conditions: Prices and volumes of the last sale and previous trades Direction of the market for the security Posted size on the bid and offer Size of the spread Liquidity of the security CLIENT PRIORITY The client priority rule (or preferential trading rule) provides that orders for the accounts of the dealer member or its partners, directors, officers, RRs, and employees (generally designated as “professional, employee, or non- client orders” or as “PRO orders”) rank behind any client order of the firm for the same security, at the same time, and at the same price. Although client orders take priority over those of house or employee accounts, PRO orders committed to a market prior to the receipt of a client order do not have to give up their standing. If a dealer member has orders in various marketplaces, checks should ensure that a PRO order is not inadvertently filled prior to a previously entered client order. In this case, it may be appropriate to give the better fill to the client. In addition, a client’s consent to share trades with a PRO account must be recorded in detail in the trade documentation (i.e., the order ticket). This consent must be specific to each order and recorded as such. Procedures addressing client consent are critical and must be clearly documented and reinforced in a compliance testing program. The most basic example is the comparison of order tickets to an official record of trade, such as the TSX Diary. © CANADIAN SECURITIES INSTITUTE 13 22 CHIEF COMPLIANCE OFFICERS QUALIFYING EXAMINATION      SECTION 4 ORDER ENTRY AND EXPOSURE Orders begin with an order ticket, whether physical or electronic. The information on the ticket is the cornerstone of an audit trail and, as such, must be accurate and complete. The following information, at a minimum, must appear on every order ticket: Security name, symbol, or description Quantity of the order Client name or account number Price of the order (on a retail fixed income trade executed on a principal basis, this should include the inventory transfer price and price to client) Type of order (e.g., call market, opening, market-on-close, special terms, volume weighted average price, basis, or program trade) Relevant order designation as defined by the regulator (e.g., type of trade, cross, short, PRO, principal, jitney, insider, or significant shareholder) Any special instructions given by the client Identity of the person who entered the order (initial or code) Time stamp Accurate and complete recording of all trade details, whether physical or electronic, is often difficult to enforce among business unit personnel, who may view the requirements as administrative and serving little purpose. CCOs should encourage the dealer member to implement electronic order entry systems that automatically record the relevant information or mandate the completion of certain data fields before an order will be processed. This requirement can be supplemented by education and awareness programs that highlight the importance that regulators attach to accurate documentation and the penalties imposed for non-compliance. Regardless of the preventive controls implemented, periodic trade ticket testing must be a part of a firm’s compliance procedures if it trades on markets governed by UMIR. DID YOU KNOW? On April 15, 2019, CIRO approved amendments to UMIR and CIRO Rules to include client identifiers and certain designations on: each order for a listed security that is sent to a marketplace; and each reportable trade in a debt security. Client identifiers will enable dealers and CIRO to more precisely differentiate institutional orders from those submitted by retail investors, as well as manage risks of electronic trading. Legal Entity Identifiers (LEI), a global identification system, are required to be obtained by institutional clients, while account numbers will serve to identify most retail client orders. Order exposure obligations must also be complied with. UMIR Rule 6.3 states that all orders of 50 or fewer standard trading units must be transmitted immediately to the marketplace. A number of permitted and accepted exceptions to this rule exist, including withholding an order to verify the specific terms of the order, to review the impact on the market or based upon client request. Orders must be executed on a marketplace in accordance with UMIR Rule 6.4 which states that “a Participant acting as principal or agent may not trade, nor participate in a trade, in a security by means other than the entry of an order on a marketplace.” The rule allows the following exceptions: An unlisted or non-quoted security An exemption granted by a market regulator on a request basis © CANADIAN SECURITIES INSTITUTE  CHAPTER 13      TRADING DESK SUPERVISION 13 23 Error adjustments; or a trade as principal with a non-Canadian account or as agents between two non-Canadian accounts The exercise or redemption of warrants, options, or preferred shares A prospectus and exempt distribution Any transaction where there is no change in beneficial or economic ownership. Otherwise, all transactions must be made on an exchange or organized regulated market TRADING IN A MARKETPLACE In addition to some supervisory and compliance obligations already discussed, Part 7 of UMIR addresses the following matters: Required proficiency of persons involved in trading Responsibility for bids, offers, and trades entered The source of official transaction records UMIR Rule 7.7 sets out the requirements and restrictions that apply during the course of transactions such as distributions. It also provides direction on market stabilization and market-balancing activities during this period. Of particular note is the restriction on soliciting trades. Other requirements relate to permissible research activities during the course of a distribution. PRINCIPAL TRADING Dealer members can act as principal in the execution of an order provided that specified conditions are met. Requirements vary among markets, because certain securities such as fixed income products may be readily available only on this basis from the firm’s inventory, whereas other products may have an active secondary market that the firm can access as an agent on the client’s behalf. Chief compliance officers should know the legal and regulatory implications of acting as principal on a trade. Under common law, the dealer member may have certain fiduciary obligations in relation to advising clients, obtaining consent, and addressing situations in which the client is particularly reliant and vulnerable. These requirements are reflected in various regulations. For example, a dealer member must state on the client confirmation that it has traded as principal. Dealer members must also notify clients that the firm may be engaging in transactions on a principal basis. Typically, clients receive this notice when they open an account. Certain conditions must be fulfilled before a firm acts as principal on a listed equity. The underlying concept is that the client must do as well as, or better than, if the trade is done on an agency basis. UMIR Rule 8.1 governs client- principal trades on a public equity marketplace with the following requirements: For client trades of 50 standard trading units or less, a Participant trading with a client as principal must give the client a better price than could be obtained on any marketplace in Canada. This requirement applies to intentional crosses and not to a cross that occurs as a result of a client order entered into a marketplace and traded with a passive Participant order (i.e., an order that was previously entered). Testing scenarios must be in place to ensure compliance with this requirement. A Participant must remember that the client has the right to assume that when it acts as agent on behalf of the client, it will do so in the client’s best interests. The client should therefore consent to the agent acting as principal. Although obtaining client consent may seem impractical when trading, the person who accepts the order should ask for consent if he or she has a reasonable expectation that the resulting trade will be a principal transaction. © CANADIAN SECURITIES INSTITUTE 13 24 CHIEF COMPLIANCE OFFICERS QUALIFYING EXAMINATION      SECTION 4 Participants should have a procedure to address situations in which a client notifies the Participant that he or she does not consent to principal trading, generally or specifically. The compliance testing system should include tests for inappropriate client-principal trading activities. It should also ensure that order tickets and trade confirmations contain the appropriate order markers. TRADING HALTS, DELAYS, AND SUSPENSIONS Most regulations and policies governing securities trading include provisions dealing with trading halts, delays, and suspensions. Some such incidents are short halts or delays in the trading of a particular publicly traded security to allow for full and proper dissemination of important news concerning the issuer. Others are permanent bans on trading in a security, such as when a cease trade order has been issued by a provincial securities commission. Typically, halts or delays apply generally, extending to OTC trading in the security and including all related securities, such as listed options. Depending on the applicable rules, trading in the security outside of Canada may also be prohibited. Trading halts, delays, and suspensions imposed by an exchange for business reasons do not prohibit trading in the security or a related security in another marketplace. Business reasons might include a company’s failure to meet listing requirements or to pay listing or other fees. Trading suspensions that result from regulatory action are often implemented through the systems of the relevant marketplace by their refusal to accept orders. However, a firm’s compliance program should address situations in which securities trade on multiple markets or OTC, where it may still be possible to execute a trade despite the suspension. EXAMPLE An issuer fails to meet its continuous disclosure obligation to file financial statements in one particular province but remains compliant in all other jurisdictions. The provincial securities commission of that one province issues a cease trade order in relation to the issuer. However, the issuer continues to trade on a U.S. market. Cease trade orders may include conditions that allow certain types of trading to continue within the province. For example, the owners of the security at the date the order was issued can continue to sell, or the order applies only to specified individuals, such as directors and officers. These orders can be temporary or remain in effect indefinitely, until repealed by the applicable securities commission. Cease trade orders may also be issued against directors and officers of an issuer, rather than an issuer. Furthermore, persons who have been disciplined for capital market misconduct may be subject to a cease trade order that prohibits them from engaging in specified trading activities. Because it is difficult for individual dealer members to monitor all cease trade orders issued by the numerous provincial and territorial securities regulatory authorities, the CSA maintains a current and complete database of all such Canadian orders on its website. Policies must define the prohibitions on trading during a regulatory halt, cease trade order or trading delay. Testing procedures ensure that inappropriate trading activity (i.e., an OTC transaction on a halted security) does not take place during a regulatory halt. AUDIT TRAIL Dealer members are required to retain a record of each order and sufficient evidence to identify the beneficial owner of each account. The record of each order must include an audit trail capability; that is, all actions relating to the handling and execution of an order must be accessible for a reasonable time so that they can be made available to the regulators. Traditionally, the audit trail began with an order ticket, but automatically generation of electronic tickets reduces or eliminates human error. Information must be sufficient to recreate order events in a timed sequence, and procedures must also be in place to track contract amendments to ensure a complete audit cycle. © CANADIAN SECURITIES INSTITUTE  CHAPTER 13      TRADING DESK SUPERVISION 13 25 EVIDENCE OF SUPERVISION AND TESTING Statistical results of compliance testing must be created, documented, and archived. This record provides evidence to regulators of a diligent testing program that not only identifies issues, but also tracks issues. COMPENSATION The following issues can arise for the CCO from actual and potential conflicts of interest created by a dealer member’s interest in compensation for trading activities: The term soft dollars refers to the use of commission dollars by clients who are institutional money managers to pay for trading related goods or services, including incidental advice and research and analytical tools, and for trade execution. A closely linked practice is directed brokerage, whereby a client commits to placing orders with a specific dealer member and uses commission payments as compensation to the dealer member for certain services, or as an incentive for preferential treatment. Favours provided in return might include client referrals or opportunities to participate in hot new issues. Commission recapture allows institutional investors to track the amount of commission dollars and, in prescribed circumstances, receive a certain percentage back. These arrangements may present a conflict of interest for the client because the client’s commission dollars are used to receive a benefit that may not be passed on to the same client, or that may benefit only the money manager. These practices may sometimes be viewed as being in conflict with the dealer member’s duty of best execution. Chief compliance officers should incorporate the following requirements into their compliance programs: NI 23-102, Use of Client Brokerage Commissions as Payment for Order Execution Services or Research Services, which refers to soft dollar deals NI 81-105, Mutual Fund Sales Practices, which includes prohibitions on directing transactions of a mutual fund to a dealer as inducement or reward for the dealer selling securities OTHER CONSIDERATIONS In addition to the various rules and compliance issues associated with trading activities, the CCO should be aware of related regulations and rules that may be administered by other functional areas within the firm. Margin and settlement requirements are typically managed by the credit and operations functions but are subject to industry standards that often overlap (and may be incorporated within) the compliance department’s mandate. EXAMPLE It is a regulatory violation to purchase securities in a cash account and sell them before the settlement date without the resources and intention to make a payment. This practice is often referred to as freeriding. A variation involves repurchasing the same securities so that the settlement date is continually moved out, a practice referred to as debit re-aging. The dealer member’s capital can also be affected by trading activities, inventory positions, and underwriting commitments. Firms engaged in proprietary trading should be aware of the controls placed over their traders to ensure that position and exposure limits are adhered to. Other trading and settlement considerations are created by the requirements of the various clearing corporations, such as the CDS Clearing and Depository Services Inc., Options Clearing Corporation, and similar entities, such as FundSERV for mutual fund order processing. © CANADIAN SECURITIES INSTITUTE 13 26 CHIEF COMPLIANCE OFFICERS QUALIFYING EXAMINATION      SECTION 4 SUMMARY In this chapter, we explored trade desk supervision in the context of two fundamental policy objectives: protecting investors from unfair, improper, and fraudulent practices, and fostering fair and efficient capital markets and confidence in their integrity. We discussed that the two basic types of securities markets are the dealer market and the auction market. In a dealer market, participating firms post bid and offer quotations, and all trades are done with a dealer member taking the other side as principal. In an auction market, a trade is made when the price a buyer is willing to pay for a security matches the price at which a seller is willing to sell the same security. We also discussed that the trading standards and requirements in CIRO rules apply regardless of the type of security being traded or the marketplace that it is being traded on. Furthermore, UMIR applies to trading in equities on all Canadian listed markets, including exchanges and ATSs. Both Participants and Access Persons must comply with UMIR. We also discussed the types of illegal activities that are criminal offences under Canada’s Criminal Code, including fraud, market manipulation, and illegal insider trading. We discussed general trading supervision requirements, as well as the requirements that apply specifically to retail and institutional trading. For example, most institutional trades are large trades that take place on a discretionary basis, whereas retail trades are typically non-discretionary trades for relatively small quantities. An important point to remember is that dealer members and registrants have heightened gatekeeper responsibilities as a result of UMIR revisions. Dealer members must not only refrain from engaging in abusive activities and have reasonable controls in place to prevent their employees from doing so; they must also monitor for potential violations by their clients and report inappropriate activities to the regulators. Regarding equity trading, we discussed that dealer members can have various models for the supervision of their trading desks, depending on the dealer member’s activities. Many trading desks have a variety of trading-related functions, each of which may have its own designated supervisor with oversight and responsibility for the group’s compliance. We also discussed CIRO’s rules addressing the supervision of fixed income products and the general principles that are common to each. Collectively, these rules enhance the fairness of pricing and transparency of OTC market transactions. Finally, we explored specific considerations related to multiple aspects of trading supervision and compliance that present varying degrees of risk for dealer members. We discussed the rules related to various improper or illegal activities, including manipulative or deceptive trades and improper orders and trades. We also explained the obligation of dealer members to act in the best interests of their clients, including the concepts of best execution, client priority, order entry, and exposure, as well as the risk of conflicts of interest inherent in some compensation arrangements. In the next chapter, you will learn more about supervision and compliance in the context of institutional investment banking. © CANADIAN SECURITIES INSTITUTE