CAT: FINRA’s Exams, Deadlines Won’t Be a Virtual Breeze

Trade compliance, regulatory operations, and technology managers at US broker-dealers will need to quickly cross their Ts and dot their I’s when it comes to documentation, data, and IT if they want to pass muster with the Financial Industry Regulatory Authority’s examiners for reporting to the new Consolidated Audit Trail (CAT) and survive one of the trickiest milestones — interfirm and TRF linkage reporting– just around the corner.

FINRA’s examiners are starting to show up at broker-dealers’ doorsteps — virtually that is– checking up on the entire reporting lifecycle and its accuracy. As of June 22, large and small broker-dealers had to report information on trades executed for customers — including institutional investors– if they had already reported on the Order Audit Trail System (OATS), a predecessor to CAT. The date was July 20 for simple options trades. By December 13, all broker-dealers must start reporting on equities and options trades to the CAT, the single largest database storing information on equities and options transactions executed on exchanges and over-the-counter. Of the estimated 1,700 brokers that must file CAT reports, about 800 have never even filed OATS reports.  That is because OATS reporting only applies to FINRA’s members, whereas CAT reporting applies to all broker-dealers registered with the Securities and Exchange Commission. The goal of CAT is to help regulators track illegal or manipulative trades more quickly in the wake of May 2010 flash crash whose cause took months to unravel. Although the SEC agreed to the creation of CAT back in 2012, its launch was marred by multiple delays with FINRA finally replacing Thesys Technologies as the CAT processor in February 2019. The processor is responsible for developing and operating CAT.

Trade compliance managers at several broker-dealers who spoke with FinOps Report are worried FINRA will crack down heavily on consistent offenders — or those who make too many CAT reporting mistakes too often– with warnings and hefty penalties. FINRA has not disclosed the methodology it will use to fine firms who can’t get their reporting in order which means less than a five percent error rate for initial submissions and two percent error rate for resubmissions. Based on FINRA’s track record of fines for poor OATS reporting, broker-dealers should expect to fork over at least US$1 million for not meeting individual CAT thresholds for errors. The threat of fines could help FINRA decommission OATS by mid-2021, if the broker-dealer community meets multiple litmus tests which include an average error rate of less than five percent over 180 days for initial submissions and of less than two percent for post-correction resubmissions. A single outlier won’t affect the thresholds, but too many will.

Given the vast amount of data and the large number of trades that must be reported, the percentages are low. The three days firms have to correct any errors flagged by FINRA isn’t that much time. It actually comes down to less than two days, because FINRA doesn’t provide feedback on any errors until 12 PM EST on T+1 (the day after the trade is executed) and firms don’t have to report trades until 8AM EST on T+1. All firms need are a few mistakes each day and within a few weeks the backlog of errors could easily become too difficult to fix quickly. Correcting mistakes on CAT reports is harder than on OATS reports. So far, broker-dealers seem to be on track to meet FINRA’s timeline to shutter OATS, but future deadlines could change the momentum. As of August 15, FINRA’s report card for CAT indicated an average error rate of 3.12 percent for equity events compared to 1.29 percent for options events based on 63.5 billion average weekly events for equities and 6.5 billion events for options.

FINRA’s examiners will expect broker-dealers complying with CAT reporting to answer the who, what, when, where, how and why in their written policies, procedures, controls, and governance, including the names of any reporting agents and third-party order management and smart-order routing systems along with their delivery models. “Policies and procedures refer to where the data is accessed from, how it is migrated to the reporting system, and who touches the data if anyone,” says Peter Gargone, chief executive of n-Tier, a New York-based software firm focused on data management for regulatory reporting. “Controls refer to how data completeness and accuracy are ensured to guarantee all of the right information is reported for events and in data fields.” The name and title of the person in charge of the CAT reporting process, likely a principal with a Series 24 license from FINRA, must be listed in the governance section along with the process used to escalate mistakes. As is typically the case with documentation, multiple departments will be involved. “Compliance departments should take charge of drafting the language explaining the policies, procedures and governance with input from the regulatory reporting department which will explain the sources of the data and data verification measures,” recommends Steven Goune, practice head of finance, risk, regulatory and compliance at Capital Markets Advisors, a regulatory compliance, risk and financial services IT consultancy in New York. “The process for data validation will likely be left to the IT department.”

Too many consistent errors in CAT reporting will likely prompt FINRA’s examiner to dig deeper into how well a broker-dealer has implemented its policies, procedures, controls and governance. It won’t matter how well-written they are, if they aren’t being followed. “The aggregation and consolidation of data into CAT reporting is a complex process with a lot of different data sources requiring a lot of data translation and transformation,” says Gargone whose firm is a FINRA-certified CAT reporting agent. “Performing the aggregation and consolidation across external and internal infrastructures will lead to some errors even in the best-case scenarios.” Reporting of options trades is entirely new and as is the case with equities, information is stored on multiple systems. IT departments will need to dig deep into the sources of data — OMS, EMS, and smart order routing systems– to verify they are coded correctly– and linked with the right reporting systems so the right data shows up on the CAT reports.

If there is a miscoding in any OMS, EMS or smart order routing system or a break in the connectivity to the reporting system, the CAT report will be wrong. Data fields might be missing or mistaken and some trades might not be reported at all. It is ultimately up to the broker-dealer to fix any deficiencies because it will be held responsible for any reporting mistakes, not the vendor. Gargone says n-Tier’s Compliance Workbench used for CAT, OATS and other regulatory reporting requirements, offers a “comprehensive” platform able to detect all types of pre-submission errors, automate pre-submission corrections, and handle post-submission exception management as well as remediation re-reporting. He would not disclose the total number of broker-dealers using Compliance Workbench for CAT reporting, but n-Tier’s recent press releases cite Cowen as one of them and highlight three broker-dealers as new CAT reporting clients.

How will FINRA know broker-dealers are going the extra mile to ensure accurate CAT reports? “Examiners will be comparing the CAT reports to OATS reports as there is a large overlap in the type of events that must be reported as well as the data fields. If the CAT and OATS reports have too many discrepancies, FINRA will suspect there are errors in both reports and start investigating the firm’s entire reporting systems,” says Goune. “However, the same also applies if there are no discrepancies as the CAT and OATS reports can’t be identical.” That is because in addition to information on executed options trades, CAT reports must also include modifications or cancellations of internal orders, proprietary orders, riskless principal orders, clearing number information, and trader identification numbers.

FINRA’s examiners will also be looking at the accuracy of specific data fields in a broker-dealer’s CAT reports, such as the account holder type; capacity; customer display tag; event price; event quantity; event time stamp and order type code. Goune says that CMA’s new managed shared service for CAT reporting offers broker-dealers a dashboard view of errors on CAT reports, including linkages and discrepancies with OATS reports, for correcting before submission to FINRA and will fix reports flagged by FINRA as erroneous. Currently CMA’s data utility service does not submit CAT reports to FINRA on behalf of broker-dealers, but CMA could seek FINRA’s approval as a CAT reporting agent in the future if there is sufficient client demand.

If broker-dealers thought they had enough problems filing correct CAT reports in June and July, they had better brace themselves for what’s next in line — interfirm linkages and TRF linkages. Interfirm linkages refer to data on trades routed from one firm to another while TRF trades are trades reported to one or more of three FINRA-regulated trade reporting facilities. They represent transactions in Nasdaq or NYSE-listed securities that were not executed on an exchange. “Both broker-dealers reporting interfirm linkages must separately report the same linkage data that enables FINRA to establish the trail between the routed order event and the routed order accepted event reported by the receiving party,” says Goune. “If the data doesn’t match both firms will be on the hook– meaning the data will be considered erroneous and included in the allowable submission error rate of five percent for each firm.” Likewise, the data on events reported to the TRFs must match information reported to CAT. “If a broker-dealer’s TRF report is rejected or the broker-dealer failed to report to the TRF its CAT trade event report will fail to match the TRF report,” cautions Gargone. “If the tape-trade ID captured on the CAT trade event doesn’t match what was reported to the TRF there will also be a break.”

So far, FINRA has let mistakes with interfirm linkages and TRF linkages slide without insisting on corrections, but that won’t be for long. As of October 26, FINRA will expect reports on interfirm linkages to be accurate for equities and as of January 4, 2021, the interfirm linkages must be accurate for options trades. The same dates apply for TRF linkages; however, interfirm linkages are expected to cause more grief. “To the extent the occurrence of mistakes in interfirm linkages is out of any one firm’s control and a large firm with reporting issues could create a domino effect of a large number of errors at counterparties,” warns Gargone.” This level of unpredictability makes it hard for broker-dealers to staff their regulatory reporting groups appropriately.”

What can go wrong with interfirm linkage data? Plenty. “A likely sore spot with the interfirm linkage data is the identification codes that firms use to signal which firm is sending a trade to which other firm and who is receiving a trade from which other firm. A huge broker-dealer could easily have several dozen, if not hundreds of market participant identification codes (MPIDs),” says Joshua Barry, chief software architect for S3, an Austin, Texas-based regulatory reporting firm and FINRA-certified CAT reporting agent. “Yet another mistake could be incompatible routed order IDs because OMS and smart order routing systems could shorten an ID code or eliminate a necessary space in an ID code.” By FINRA’s estimates, order ID mismatches accounted for 77 percent of all interfirm linkage errors so far, while sender ID mismatches accounted for anywhere from 13 percent to 15 percent and receiver ID mismatches were at six percent. About 33 percent of interfirm linkage errors were related to equity trades and about 16 percent involved options trades.

Because errors in reporting interfirm linkages cannot be corrected entirely without human intervention, regulatory reporting managers will likely be spending lots of time calling their counterparties at different brokerages to escalate disputes to compliance and IT executives. “Compliance directors should have a list of the MPIDs for their firms and it will be up to technology managers to ensure they verify they are accurate in OMS, EMS, and smart order routing systems,” says Barry. “Likewise, technology managers will have to correct errors with routed order IDs.” The Financial Industry Forum, a New York based trade group focused on regulatory compliance and market data management, has come up with a list of individuals to contact at broker-dealers to fix interfirm linkage errors.

Broker-dealers bemoaning all the corrective work they have to do now with CAT reporting will hopefully feel better soon. Getting a head start on fixing current CAT reporting problems will give them more time to prepare for the ultimate challenge– reporting correctly on customer linkages or the underlying customer account to which an order belongs. “It will all come down to how quickly a broker-dealer updates customer information which can be as broad as whether a customer remains a registered investment adviser or has merged with another firm to as narrow as a customer’s address,” says Goune. “That’s not hard for a broker-dealer to do for a few hundred customers, but some Wall Street wirehouses can easily have more than five million customer accounts.” One answer: more frequent communications with customers instead of the typical two-year cycle.