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JPMS Fined $800,000 for Failure to Supervise and Pre-Trade Controls

A Case for At-Trade Risk Management

JPM accepted a fine for $800,000 because they “failed to establish, document, and maintain a system of risk management controls and supervisory procedures, including written supervisory procedures and an adequate system of follow-up and review, reasonably designed to manage the financial, regulatory, and other risks of its market access business.”[i]

The regulatory fine points out a number of problems. These include:

  • Inadequate pre-trade controls.
  • Complex order routing through multiple trading systems
  • Ability for the traders to override pre-trade risk controls through the use of “Soft-blocks” instead of hard controls
  • Pre-trade controls that were set to benefit the trader and not to protect the firm or the markets.
  • Pre-trade controls that were “generally set too-high to be effective.”[ii]
  • Order message controls “employed soft-block alerts for order or message activity, rather than any hard-blocks, that could be overridden, and the levels set for the alerts were too high to identify potentially unintended messaging activity.”[iii]

Edge Financial Technologies has recognized the pattern of issues related to this fine. We have seen it multiple times. Consider the following:

Traders:

  • Want speedy execution to avoid market slippage.
  • Want multiple trading systems (backup, additional functionality, algos, etc.)
  • Have market experience that must operate in real time
  • Produce the revenue that drives the firm

Risk & Compliance:

  • Are a cost center
  • Review activity after the fact and have the luxury of hindsight
  • Are required to have oversight

IT & ISVs

  • Take direction primarily from the profit centers

When the developers who are putting in the pre-trade risk systems gather requirements they are often encouraged, to “meet the minimum” risk requirements and compliance because execution slippage is expensive. Over time all trading systems change. The changes may be settings, or may be new features, or additional functionality. Regardless of the change, pressure on the “minimum” requirements builds and sooner or later a fault appears.

Our belief is that this is what occurred at JPMS. We doubt anyone initially designed the order routing technology to have these faults. The pressure of new integrations, parameter changes, new markets all build to introduce a fault line in the order processing systems.

A systematic risk management program should address the pressures on the system by implementing a new level of oversight using At-Trade risk management technology

What is At-Trade Risk Management?

At-Trade risk management oversees the trading activity in near real time across all exchanges, accounts, traders, and technology with the capability to alert and take manual or automated action that is appropriate to the situation.

The action should be appropriate and not increase the risk to the trading accounts or the trading firm.

At-Trade became possible when software vendors, like Trading Technologies[iv], CQG[v], and others began introducing streaming drop copies of all order transactions along with application programming interfaces to interact with account and trader pre-trade setups. The CME[vi] and ICE[vii] have provided streaming drop copies and exchange level pre-trade controls. Other exchanges are following their lead.

The Benefits of At-Trade Risk Management

The implementation of a documented system with appropriate processes of At-Trade Risk Management proves that there are valid supervisory procedures.

While changes to the order processing systems occur, there will be a secondary system that will not be affected by the pressures associated with change. No matter how many changes occur, the order traffic remains. The drop copies of all traffic still flow into the At-Trade Risk Management System.

Escalating actions can be setup to allow a system of alerts, warnings, and actions that appropriately deal with order flow and messaging issues.

Learn more about the Edge Financial Technologies at

www.EdgeFinite.com 

 Rules Cited By The Regulator

Footnotes

[i] BATS BZX EXCHANGE, INC. Letter of Acceptance, Waiver and Consent No. 20120348296-04 Re. J.P. Morgan Securities LLC Respondant http://cdn.batstrading.com/resources/regulation/disciplinary/2012/BEST-EDGX-20120348296-05-AWC.pdf
[ii] ditto 
[iii] ditto

[iv] https://www.tradingtechnologies.com/platforms/fix/

[v] http://partners.cqg.com/api-resources

[vi] https://www.cmegroup.com/confluence/display/EPICSANDBOX/Drop+Copy+4.0 and https://www.cmegroup.com/confluence/plugins/servlet/mobile?contentId=78447186#content/view/78446746

[vii] https://www.theice.com/technology/isv

 

SEC Market Access Rule 15c3-5

The Securities and Exchange Commission (“Commission” or “SEC”) is adopting new Rule 15c3-5 under the Securities Exchange Act of 1934 (“Exchange Act”). Rule 15c3-5 will require brokers or dealers with access to trading securities directly on an exchange or alternative trading system (“ATS”), including those providing sponsored or direct market access to customers or other persons, and broker-dealer operators of an ATS that provide access to trading securities directly on their ATS to a person other than a broker or dealer, to establish, document, and maintain a system of risk management controls and supervisory procedures that, among other things, are reasonably designed to (1) systematically limit the financial exposure of the broker or dealer that could arise as a result of market access, and (2) ensure compliance with all regulatory requirements that are applicable in connection with market access. The required financial risk management controls and supervisory procedures must be reasonably designed to prevent the entry of orders that exceed appropriate pre-set credit or capital thresholds, or that appear to be erroneous. The regulatory risk management controls and supervisory procedures must also be reasonably designed to prevent the entry of orders unless there has been compliance with all regulatory requirements that must be satisfied on a pre-order entry basis, prevent the entry of orders that the broker or dealer or customer is restricted from trading, restrict market access technology and systems to authorized persons, and assure appropriate surveillance personnel receive immediate post-trade execution reports.

The financial and regulatory risk management controls and supervisory procedures required by Rule 15c3-5 must be under the direct and exclusive control of the broker or dealer with market access, with limited exceptions specified in the Rule that permit reasonable allocation of certain controls and procedures to another registered broker or dealer that, based on its position in the transaction and relationship with the ultimate customer, can more effectively implement them. In addition, a broker or dealer with market access will be required to establish, document, and maintain a system for regularly reviewing the effectiveness of the risk management controls and supervisory procedures and for promptly addressing any issues. Among other things, the broker or dealer will be required to review, no less frequently than annually, the business activity of the broker or dealer in connection with market access to assure the overall effectiveness of such risk management controls and supervisory procedures and document that review. The review will be required to be conducted in accordance with written procedures and will be required to be documented. In addition, the Chief Executive Officer (or equivalent officer) of the broker or dealer will be required, on an annual basis, to certify that the risk management controls and supervisory procedures comply with Rule 15c3-5, and that the regular review described above has been conducted.

Full text of the rule can be found on the SEC’s website.

Key US equity players urge SEC adopt abnormal trading controls (Reuters)

Key players in the U.S. equity marketplace, including exchanges, brokerages and trading firms, called on U.S. regulators to set limits and track trading activity after a glitch caused Knight Capital Group to incur a $440 million loss this summer.

A core nucleus of entities involved in the transaction of U.S. securities, including a clearing house and a watchdog agency for brokerages, urged on Friday that the Securities and Exchange Commission develop controls to better detect abnormal trading behavior in real-time.

The so-called Industry Working Group of 16 brokerages and trading firms, along with five U.S. stock exchange operators and the Financial Industry Regulatory Authority, also urged the SEC to evaluate whether a longer-term consolidated control mechanism could be built at the Depository Trust & Clearing Corp.

See full article on Reuters