FINRA recently provided an update on the August 2021 review of its members’ practices and controls related to the opening of options accounts and related areas, including account supervision, communications, and diligence.
Options activity has been the focus of increased regulatory scrutiny during the past couple of years. The sweep was FINRA’s response to the significant increase in retail options activity during the pandemic and around the meme stock events. FINRA launched the sweep soon after announcing its settlement with a well-known retail broker-dealer, citing that firm’s failure to exercise reasonable diligence prior to approving customers for options trading.
Options activity will be a continued source of FINRA and SEC scrutiny in 2023. Areas likely to be in focus include payment for order flow, best execution, exchange fee rebates and credits, Reg. BI, and Rule 605 and 606 disclosures.
On December 14, 2022, the SEC will hold an open meeting to consider rulemakings in several of these areas. In particular, the open meeting agenda includes a proposal to require firms to route retail equity orders into auctions to increase competition. It will be interesting to see whether and to what extent the decades of experience with auctions in the options markets factor into this rulemaking.
During the open meeting the Commission will also consider proposed new Regulation Best Execution, which would establish a best execution standard and require detailed policies and procedures for brokers, dealers, government securities brokers, government securities dealers, and municipal securities dealers, and more robust policies and procedures for entities engaging in certain conflicted transactions with retail customers, as well as related review and documentation requirements. Firms will need to be mindful of how this yet-to-be-seen rule dovetails with FINRA Rule 5310 and FINRA Regulatory Notice 15-46 in which FINRA provided guidance on best execution obligations in equity, options, and fixed income markets.
Another options market development is a recent FINRA proposal to require end-of-day trade reporting for OTC options with terms that are identical or substantially similar to listed options. FINRA noted that the proposal is designed to “improve FINRA’s surveillance of the securities markets as well as cross-product and cross-market surveillance.” It will be interesting to see if the SEC approves the proposal and, if so, what the resulting benefits and burdens will be for market participants (and the regulators).
The industry will also see a 17th options exchange come online in 2023 (MEMX), which should serve to increase regulators’ emphasis on these focus areas.
What Did FINRA Cover in the Sweep?
The FINRA sweep update provides firms with a laundry list of regulatory obligations (inclusive of relevant rules) as well as a list of questions firms can use to assess, refine, and develop their options supervisory systems and procedures, options account approvals, and options disclosures. Compliance with Regulation Best Interest is a consistent theme throughout each of these.
Firms are required to implement processes and procedures for approving customer accounts for options trading. This diligence obligation can be accomplished by reviewing the completeness and accuracy of account applications and confirming customer eligibility to trade options. FINRA observed that firms employ manual and automated processes (and sometimes a combination of both) to supervise the account approval process. FINRA provided firms with several topics to help them evaluate their option account approval processes, including:
- Tailoring minimum account approval criteria to the risks associated with options-trading levels (e.g., comparing investment objectives with options-trading level) or options-trading strategies (e.g., heightened requirements for complex options trading).
- Reviewing applications for completeness and red flags (e.g., inconsistencies with information in the application compared to other information provided by customers).
- Complying with Reg. BI if firms recommend that retail customers trade options.
- Establishing systems and controls to identify and remedy circumstances where customers resubmit applications with different information, or where the firm erroneously approves applications, or where customers trade above approved levels.
Firms must provide customers with the ODD (the Options Disclosure Document) and other disclosures and information about options accounts and options trading. FINRA provided firms with several topics to help them evaluate their disclosure processes, including:
- Ensuring that promotional options communications include required risk disclosures.
- Tailoring promotional options communications to prospective customers with varying backgrounds or limiting distribution of those communications to customers who satisfy the firm’s options eligibility criteria.
- Providing customers with the ODD and additional options-related disclosures (e.g., explaining how firms manage expiring options contracts and risks associated with options trading and expiration) and at appropriate times (e.g., at account opening and when a customer is approved for a higher level of trading).
- Providing retail customers with Reg. BI disclosures if the firm or its personnel recommend that customers open an options account or transact in options or an investment strategy involving options.
Firms must maintain supervisory systems and written supervisory procedures related to options account approval, trading supervision, communications (including disclosures), and due diligence. FINRA provided firms with several topics to help them evaluate the adequacy of their supervision of options accounts and options trading, including:
- Centralizing review of higher-level options activity or all options activity by a Registered Options Principal.
- Conducting periodic, ongoing reviews of option trading activity to confirm whether customers satisfy firm eligibility criteria and are not trading above approved levels.
- Surveilling customer account information and profiles to ascertain whether trading eligibility remains appropriate.
- Reviewing trading eligibility when market conditions change.
The list of questions FINRA provided is resourceful and provides a baseline of what firms can expect to see during future exams. However, it is certainly not exhaustive and firms can expect scrutiny in other options-related areas as the 2023 exam season kicks off. Firms will likely gain additional insight related to options scrutiny when the SEC’s Division of Examinations publishes its list of priorities for 2023 and FINRA publishes its 2023 Report on its Examination and Risk Monitoring Program. We will keep an eye out for both of those in the coming months and provide updates whenever possible.