Not in the CARDS? US Clearing Brokers Protest Customer Reporting

A new reporting plan designed to flag possible misbehavior by US brokers, is drawing backlash from their back-office correspondent clearing firms responsible for complying.

Their complaints? They run the gamut from the overwhelming costs and liabilities involved in following new rules to questions of how the Financial Industry Regulatory Authority (FINRA) is going to manage the flood of data without coming back to bother the brokers to sort out their inability to build an accurate analytical model.

The proposal reporting program, called the Comprehensive Automated Risk Data System (CARDS), was introduced to the industry in December 2013. But acknowledging the potential difficulties in implementation, the comment period for the proposal was extended from February 21 to March 21.

FINRA intends CARDS to compile information on account activities so it can run complex analytics to flag potential problems in sales practices: churning, excessive commissions, pump and dump schemes, markups and mutual fund switching. The information FINRA wants is held on the books and records of the brokerages themselves, if they are self-clearing, or held by third-party clearing brokers. So-called introducing brokers which outsource their back-office work would have to provide the account information to their clearing firms to forward to FINRA.

The data is similar to what FINRA currently gathers on a firm-by-firm basis during examinations, but FINRA says that retrieving the information prior to exams would help identify investor risks earlier. It could then uncover potential fraud for a more thorough investigation. In a test of the concept using information from an individual and two clearing brokers, the regulatory agency reports that it pinpointed potential investor harm. “For example the analytics showed FINRA that a firm was selling a new high-risk product — a business in which the firm was not historically engaged and its financial reporting did not disclose,” says FINRA.

But clearing firms say they don’t have access to the end investor and for data privacy reasons, they don’t think they should be submitting information which could reveal investors’ identities to either FINRA, or potentially other regulatory agencies. Even worse, the data could fall in the wrong hands.

FINRA initially said it wanted clearing brokers to disclose account types and categories, customer investment profiles, purchase and sale transactions, additions and withdrawals, margin and balances and a description of securities. Also included would be identifiers for beneficial owners or “control persons.” However, in March the regulatory agency bowed to overwhelming concerns expressed by clearing  brokers and individual investors to not ask for information that would identify the individual account owner, particularly the account name, address and tax ID number.

No ROI

Still, clearing brokers aren’t entirely satisfied with FINRA’s concession. Not only is there no way for FINRA to ensure confidential data won’t be compromised, but it will be dumping a lot of technological development work on clearing brokers — an investment which can’t even be quantified. In a letter to FINRA that is representative of the clearing brokers’ stance, Dallas-headquartered Apex Clearing cites a litany of new systems or dramatically modified existing systems to collect data including elements they do not currently receive from introducing brokers, new storage capacity for maintaining the data for an unspecified period, new methods to standardize data formats, and new ways of transmitting vast amounts of data to FINRA.

Presuming they can successfully implement the hardware and software necessary to gather and transmit the data, clearing brokers would also incur ongoing expense, including interacting with introducing brokers to ensure they receive the correct data.

Even worse, all the hard work would be largely be pointless. “The most likely outcome of CARDS is that the vast amount of data being collected without associated context would give rise to many more red herrings, such as false positives, mismatched records and data standardization anomalies that will have to be investigated with member firms,” says Apex Clearing in its letter to FINRA. The regulatory agency would ultimately be wasting its time unnecessarily chasing “rabbit holes” by making “unfocused, preliminary inquiries and innumerable efforts” to understand the data in advance of exams.”

Self-clearing brokerage Charles Schwab agrees that introducing brokers would be responding to unnecessary questions because FINRA is unlike to be able to pinpoint any sales practice and business practice misconduct by going over the millions of data points it will collect. Thomson Reuters, for one, has estimated that based on its interpretation of CARDS’ requirements, its back office BETA system could be sending FINRA data on nine million transactions daily.

The differences in business models and policies as well as procedural controls between brokerages make any comparison of data across firms virtually impossible. What’s more, FINRA won’t even have the information it really needs — such as customer contact notes, says Schwab.

Rejecting Liability

Although FINRA suggests that clearing brokers would be mere conduits of information passed along from their introducing brokers, Apex Clearing worries that stance isn’t enough to absolve clearing brokers of responsibility and potential liability. Regulators and investors will expect clearing brokers to review and analyze the information to catch potential fraud themselves. Therefore, FINRA should explicitly state the “affirmative obligation” of introducing brokers to provide the necessary information to clearing brokers with the later taking “absolutely” no responsibility to review the data.

Fidelity Investments, parent to clearing agent National Financial Services (NFS) and introducing brokerage Fidelity Brokerage Services, is also concerned about the additional legal risk clearing brokers could face when FINRA blurs the current clear lines of demarcation between the responsibilities of introducing and clearing brokers. After all, introducing brokers, not clearing brokers, are the responsible for interfacing with end customers.

“We believe that FINRA should clearly articulate in any future rulemaking on CARDS that simply because a clearing firm provides introducing broker-dealer customer data to FINRA, the clearing firm is not responsible for the accuracy of such information,” say NFS and Fidelity Brokerage in a joint letter to FINRA. Similarly, FINRA should clearly state that a clearing firm is not required to retain information that it obtains from introducing broker-dealers to submit to FINRA. “We believe that these actions are necessary in order to obtain the traditional and limited specialized role of clearing firms.”

In a footnote to their letter to FINRA, Fidelity’s subsidiaries also recommend that FINRA allow clearing firms to sign a separate contract or letter of intent with their introducing broker customers outlining their respective roles and responsibilities with regards to CARDS.

Leveraging CAT

Despite their criticism of how FINRA has designed CARDS, clearing firms and others say they do understand the regulatory agency’s objectives. It has just gone about achieving a noble goal the wrong way. A better alternative: leverage the new Consolidated Audit Trail (CAT) System, US exchanges and FINRA are now developing to fulfill a rule passed by the Securities and Exchange Commission to help regulators capture information regarding securities quotes and deals through a single new data repository. Each broker-dealer and securities exchange reporting the information would be assigned a unique identifier as would each customer.

“The SEC, FINRA and other self-regulatory organizations developing CAT should coordinate on the implementation of the two platforms or at the very least FINRA should delay the implementation of CARDS until CAT is fully functional,” recommend NFS and Fidelity Brokerage.

The Financial Information Forum, a New York-based trade group of data and financial operations specialists, goes a step further in more clearly explaining the merits of expanding the CAT initiative to incorporate FINRA’s needs. “It is important to recognize that CAT is more than just a set of data elements — it is a data model, a transmission mechanism, and a set of operational compliance processes,” writes FIF in its letter to FINRA. “A consistent data model for order transaction, account and position data would allow for better surveillance and easier implementation.”  What’s more, if CARDS were build off of CAT, firms could have a consistent workflow to manage their processes for both CARDS and CAT.

While capitalizing on CAT might sound like a good idea, it is unclear whether FINRA will want to do so as CAT is still not fully fleshed out — an operator for the platform has yet to be selected.

Schwab has another alternative — enhancing FINRA’s Automated Exchange Program. “Using AEP, FINRA could receive large and representative samples of standardized information against which it could run is own sales practice data analysis,” says the self-clearing brokerage. “Enhancement of AEP could be implemented much more quickly and cheaply than CARDS and maintained at a small fraction of the cost with fewer risks.”

The reason: the data required by FINRA’s new proposal, says Schwab, would require substantial translation and standardization before being submitted because the formats won’t be based on the popular FIX protocol used for order and trade data. Even worse, any time a change is made to the upstream systems which feed the data to FINRA’s CARDS, clearing brokers would have to retest all of the applications involved.

Bottom line: clearing firms don’t like the CARDS FINRA is dealing, and are suggesting the regulatory giant go back and reshuffle the deck.