grant thornton - broker-dealer industry hot topics - symposium

Highlights from Grant Thornton LLP’s broker-dealer industry symposium

Broker-dealer industry hot topics

On June 19, 2012, Grant Thornton hosted a panel discussion on the major issues facing the broker-dealer industry. The discussion was hosted by Nichole Jordan, the firm’s National Banking and Securities Industry leader. It was moderated by Lee Pacchia, legal analyst and host of Bloomberg Law multimedia programs. The panel comprised several broker-dealer industry professionals, including these industry experts:

• StevenLofchie,partner,Cadwalader• KevinPiccoli,deputydirector,DivisionofSwapDealerand

IntermediaryOversight,U.S.CommodityFuturesTradingCommission(CFTC)

• LannyA.Schwartz,partner,DavisPolk&WardwellLLP• GraceVogel,executivevicepresidentofmemberregulation,

FinancialIndustryRegulatoryAuthority(FINRA)

The following are edited transcripts and summaries of panel discussions from the conference. In all cases, the speakers’ comments represent their own views and are not necessarily thoseoftheirrespectiveorganizations,GrantThorntonLLPorits clients, or any other entity. The information provided may not and should not be construed to imply endorsement or even support by Grant Thornton LLP of the views expressed herein.

The panelists addressed a number of current issues facing the broker-dealer industry. The issues discussed included environmental pressures, changes in the regulatory atmosphere, enhanced customer protection rules, and margin changes and technology changes, including the use of social media.

Environmental pressuresThe discussion stressed that the two major drivers that impact the industry relate to the inability of broker-dealers to address liquidity and collateral certainty. Effective implementation of the rulemaking and regulatory initiatives discussed here is dependent on adequately addressing these issues.

• Basel III–Recentfinancialcriseshavehighlightedweaknesses in the global regulatory framework for financial firms.Asaresult,theBaselCommitteeonBankingSupervision has adopted the global regulatory standard known as Basel III. It covers bank capital adequacy, stress testing and market liquidity risks. The Basel III initiative will put increased pressure on broker-dealers’ profitability, particularlyonreturnsonequity(ROE)giventheincreasedcapital and margin requirements. Balance sheets will also be reduced because of increased leverage requirements.

One of the challenges broker-dealers are facing under Basel III is how to replace or increase their revenues to maintain theROEsthatshareholdershavecometoexpect.Froma sales practice perspective, regulators are concerned that new products originally developed for institutional clients are now being sold to retail customers, which may not be appropriateforthem.AccordingtoPanelistGraceVogel,while all the regulations governing the securities business took many years to develop, the regulations governing the derivatives space evolved over a much shorter period oftime.And,sheobserved,asswapsmovetoexecutionfacilities and central clearing under the new guidelines, margins to dealers will be dramatically reduced.

Regulatorshavebeenchallengedtofindtheappropriatemodel to determine the amount of capital that has to be maintained by broker-dealers. The value-at-risk model for tradingassetsiscurrentlyinuse,butaccordingtoVogel,that model presents challenges because it is accurate only 99 percent of the time. This means that one out of every 100dayswillresultinalossthatexceedsthemodel,Vogelsaid.Asaresult,theSECandtheCFTChavesetminimumcapitalrequirements.UnderitsConsolidatedSupervisedEntityprogram,theSECrequiredthatbroker-dealershaveatleast$5billionintentativenetcapital(i.e.,netliquidassets).However,thisprovedtobeinsufficientinthecaseofLehman Brothers in 2008, when a lack of liquidity exposed thefirm’sinabilitytorealizethemeasuredfairvalue.VogelindicatedthatFINRAisnowplacingmuchmorefocusonliquidity, asking firms to maintain sufficient liquidity at the broker-dealer level rather than at the holding company, and to perform stress testing to ensure liquidity is available when needed.WhilecurrentlytherearenodefinitiveSECrulesgoverningliquidity,Vogelexpectstoseesomeliquidityrulesfor securities-based swap dealers proposed this summer.

• Dodd-Frank implementation (Uniform Fiduciary Standard) –UnderDodd-Frank,theSECismandatedtostudy the need for establishing a uniform federal fiduciary standard of care for broker-dealers and investment advisers whoprovidepersonalizedinvestmentadvice.AccordingtoVogel,FINRAbelievesafiduciarystandardisappropriateforallcustomers,includingbrokeragecustomers.However,FINRAdoesnotbelieveeveryclientissuitableforafee-based account, which may result in higher charges, and does believe clients should have the option to have a self-directed account for which they are charged on a commission basis. In a fee-based account, the customer is generally charged separately for each service provided, while a commission charge is incorporated into the transaction itself.

TheproposedInvestmentAdviserOversightActsuggestsshiftingtheregulationofinvestmentadvisersfromtheSECtoFINRA.PanelistLannySchwartzindicatedthatthetopicof self-regulation for investment advisers has been around formanyyears.Heagreesthatthereareimportantcustomerbenefits. This was highlighted in part by the Madoff crisis, whentheprincipalregulator—theSEC—didnothavesufficient manpower to perform timely examinations of themorethan12,000advisers.(TheSECdidperformanaudit of the Madoff broker-dealers, although the extent of the clients who had invested in Madoff-managed accounts throughotheradviserswastheexaminationfailureissue.)AccordingtoSchwartz,asthebroker-dealerandinvestmentadvisorybusinessesconverge,utilizingFINRAastheself-regulatoryorganization(SRO)forinvestmentadviserswould promote a common set of standards and approaches forexaminations.WhiletheSEChasreviseditscustodyexaminationrequirements,installinganSROwouldsupportimprovements to investment adviser examinations.


TheproposedInvestmentAdviserOversightActsuggestsshiftingregulationofinvestmentadvisersfromtheSECtoFINRA.

• JOBS Act regulation – The Jumpstart Our Business Startups(JOBS)ActthatwasrecentlypassedbyCongressbrings two major reforms to securities law: changes to the IPO process and facilitation of capital access to private companies. But what are the consequences for broker-dealers on the research side? Panelist Steven Lofchie sees a contradictionintheregulation;forexample,theCFTChasbeen tightening its regulation of institutional research on interestratesandFX,whiletheSECisderegulatingresearchon emerging growth companies meant for retail investors. Schwartzpointedoutthatthelegislationisanexampleofthe trade-offs that come with securities regulation, because theJOBSActmayallowsmallbusinessestomoreeasilyraise capital and access the IPO market.

• Uncertainty regarding the Volcker Rule –TheVolckerRulehascreateduncertaintyforfinancialinstitutionsandthe financial markets in general. Lofchie sees difficulty in regulating non-U.S. financial institutions because that effort may negatively affect international relations with theseinstitutionsandcouldaffectU.S.jobs.Healsoseesdiminished liquidity and widening spreads in the market. Ontheotherhand,Vogeldoesnotbelieveliquiditywillbeaffected, indicating that there are many market makers that canprovideliquiditynotsubjecttotheVolckerRule.

• Risk review update–PanelistKevinPiccoliindicatedthatliquidity is one of the main risk factors driving firms into troubledsituations.HeanticipatespressureonU.S.firms,particularly the parent companies of futures commission merchants(FCM),asaresultofdowngradesonsomebankscoupled with the European situation. It is important to understand the risk elements in order to keep customers’ fundssafeandsecure.Fromanexaminationstandpoint,PiccolinotedthattheCFTCwillbetakingacloserlookatthe risk profiles of firms and the effect on customers.

• Segregation and secure control locations for customer funds–PiccolisaidthattheCFTCwillberecommendingchanges to the method of computation for secured funds. FCMsshouldbeusingthenet-liquidatingequitymethodto compute the secured amount versus the alternative method, which can leave any unused portion of customers’ fundsexposedtoloss.PiccoliindicatedthattheCFTCwillbeissuingalettertoFCMsinthenearfuture,addressingcomputationmethods.Heexpectssomeregulationsregardingsecuredfundstobeforthcoming.HealsomentionedthattheCFTCiscontemplatingwhetherFCMsshould be required to disclose the location of the secured assets and to what extent that location should be made available to the public.

• Proposed elimination of credit ratings in SEC rules – UnderDodd-Frank,theSEChasproposedremovingreferences to credit ratings within the credit agency rules and, where appropriate, replacing them with an alternative standardofcreditworthiness.Vogelsaidthatno-actionletters making reference to credit ratings will continue to exist,buttheSECisplanningtochangethelanguagewherereferenceismadetoanationallyrecognizedstatisticalratingorganization.

• Importance of broker-dealers’ custody practices – Lofchie emphasizedtheimportanceofthecustodyruleforbroker-dealers and advised firms to take a closer look at their foreign controllocationagreements.Headdedthatthetreatmentofaffiliateaccountsisaveryimportantissue.Vogelcommentedthat there have been instances in which firms have lost significant amounts of money because they did not review transactions closely enough; the transactions were masked because they were done on an intracompany basis.


• Proposed additional documented procedures for clearing firms–ProposedFINRARule4516willrequireclearing,carrying and self-clearing firms to store certain records (e.g.,listsofresponsibleparties,accessletterstoallcontrollocations,detailedproceduralwrite-ups)inacentralizedphysical location at the principal office to enable regulators to take prompt action to protect investors in the event of a liquidation.Afterreceivingcommentsfrommemberfirms,FINRAismakingsomemodificationstotheproposedrule,including narrowing the universe of firms subject to the rule.

• Use of social media and areas of concern–Withtheproliferation of social media use by broker-dealer personnel, FINRAhasdevelopeddetailedguidanceformemberfirms.AnycommunicationmadewiththepublicfallsunderSECrules and must be supervised and retained by the broker-dealer.Aregisteredprincipal(principal)mustapprovetheuse of any social media site prior to its use by an associated person.Anycommunicationthatrecommendscertainproducts may trigger the suitability rule, and additional disclosuresmayberequired.Certainsocialmediameetthe definition of a public appearance, such as participation inonlineforums,chatroomsandseminars.Whiletheseactions do not need prior approval, a post-review would be required. Blogs that contain certain static content fall under theSEC’sadvertisingrulesandrequireprincipalreviewpriortouse.UseofFacebook,TwitterandLinkedInalsoneed to be supervised, and depending on how the associated person is using them, may require pre- or post-review. Third-party posts are also an area of concern because theycouldbeattributedtothefirm.Anylinkstoathird-party also raise concerns because these sites may contain misleading or incorrect information.

The use of personal devices by broker-dealer personnel is alsoanareaofuneasiness.Vogelreferredtoitas“BringYourOwnDevice”becausemanyfirmpersonneldonotwant to carry several devices and prefer to be able to access all of their work on their own personal device. The broker-dealer needs to be able to retain and supervise all of the activity on that device. Many firms are asking personnel to sign an annual attestation of compliance with firm polices.

Additional areas of focus• FINRA Rule 4524 (Rule 4524)–Rule4524allowsFINRA

tocollectinformationsupplementarytotheFinancialandOperationalCombinedUniformSingle(FOCUS)report.AccordingtoVogel,theFOCUSreportisanSECform,first approved in the mid-70s, that has become outdated. TheSEChasrecentlyapprovedRule4524,whichallowsFINRAtocollectinformationsupplementarytotheFOCUSreport.Eachformmustgothroughthecommentperiod and rulemaking process; the first form that was approved is a detailed income statement that must be filed by every firm on a quarterly basis, with the first filing due for the period ending Sept. 30, 2012. This information will giveFINRAabetterunderstandingofhowthefirmismakingmoneyandwhatitsexpensesare.FINRAwillalsorequire additional information from firms that, during a reporting period, derive more than 10 percent of their total revenues from participation in unregistered offerings.

The second form, which is applicable only to carrying and clearing firms, is a proposed supplemental off-balance sheet schedule, designed to give better insight to off-balance sheetitems.InthecaseofMFGlobal,severalriskswerenot detected because they were off-balance sheet items and were identified only after the annual audited financials were released. There were some concerns regarding the confidentialityoftheschedule,butVogelassuredtheaudiencethatFINRAdoesnotmaketheFOCUSreportavailable to the public, and therefore would not make the supplemental schedule available either.


• Creation of swap data repository and areas of concern –UnderDodd-Frank,marketparticipants—particularlyswap dealers — need to report certain data elements to a registeredswapdatarepositoryortheCFTC.Theindustryhas many concerns about the structure, including the ability of firms to gather all the information required in the time frame put forth by the rule. There are also concerns about the swap data repositories themselves, including how they operate, what their technical standards are and the security of the data. Given the complexity of the swaps data,Schwartzvoicedconcernoverhowintelligibletheinformation will be and how market participants will be required to use it.

• Information learned from the May 6 flash crash – On May6,2010,theDowJonesfellalmost700pointsinlessthan30minutesinaneventdubbedthe“flashcrash.”Pacchiaaskedwhatwehavelearnedfromit.Vogelindicatedthat there is a more rational uptick rule that should prevent thesamethingfromhappeningagain,aswellasSECRule15c3-5, which is the direct-market access rule requiring firms to put controls in place.

• High-frequency traders (HFT) and potential restrictions –AccordingtoVogel,HFTsarguethattheyprovideliquiditytothemarket.However,shesaiditisoftendifficulttodistinguishbetweenanHFTandamarketmaker.LofchiefeelsthattheSEChastakenawayalotoftheincentivetobeamarketmaker,andbydefault,theHFTshavebecomemarket makers.

• Proposed efforts to increase customer protection–Asself-regulatoryorganizationsforthefuturescommission,theNationalFuturesAssociationandtheChicagoMercantileExchange merchants have proposed rule amendments to increase customer protection. In addition, Piccoli said the CFTCisexpectingeachfirm’schiefcomplianceofficer(CCO)totakeanactiveroleinensuringtherightareasarebeingreviewed.TheCFTCisproposingthatCCOsofswapdealersandFCMsperformanannualcertificationstatingthatpolicies, procedures and controls have been reviewed and areinposition.ThisproposedruleissimilartoFINRARule3130,whichrequiresCEOsortheirequivalenttoannuallycertify firm compliance policies and supervisory procedures. TheCFTCwillalsobefocusingontheamountofexcessinthe funds required to be segregated or secured. This amount is traditionally viewed as the cushion, or as Piccoli called it, thetargetlevel.Firmswillnowberequiredtodisclosehowthe target level is determined, and they will be required to notifytheCFTCiftherearechangesinthelevel,andwhy.Ifmore than 25 percent of the excess is withdrawn, this action mustbeapprovedbytheCEOorCFO.

• FINRA Rule 5310 (Best Execution Rule)–FINRARule5310(Rule5310)isthenewconsolidatedrulegoverningmembers’ best execution requirements. Moderator Lee PacchiaaskedwhetherRule5310willprovidemorecomfortto investors, and if regulators are focused on the right issues. Lofchie feels that the equity markets are incredibly efficient, withverylittlefluctuationinpriceonewayoranother.Additionally,Lofchiefeelsthereareotherissues,suchasliquidity, that are more deserving of attention from firms and regulators.Fromaregulatoryperspective,hethinksthatbestexecution practices are a relatively low regulatory priority.


Giventhecomplexityoftheswapsdata,Schwartzvoiced concern over how intelligible the information will be and how market participants will be required to use it.

The principal message from our panel of experts is to properly assess liquidity and provide adequate levels of capital tosustainafirmintroubledtimes.Firmsshouldconstantlyverify their ability to timely recover assets maintained in separate control locations, regardless of the legal status.

• Status of SEC rules –TheSECisworkingonfinalizingthenewFormCustodyreport,whichwilrequireinformationabout how a broker-dealer maintains custody over customer andnoncustomerassets.Vogelsaidsheexpectsthenewformtogointoeffectinthefirstquarterof2013.TheSECis also planning to adopt a rule requiring a report from auditorsindicatingcompliancewithSECRules15c3-1,15c-3-3 — the customer protection rule — and 17a-13, which requires a broker-dealer to count the securities it holds for customersandforitself.Furthermore,theSECisplanningto adopt a rule that would require auditors to speak directly totheSECtoreviewtheirriskassessmentprocesses.

• Inclusion of previously unregistered derivative entities as major swap participants – Piccoli indicated that it will be interesting to determine who actually qualifies as a major swapparticipant.TheCFTCcurrentlyanticipates125swapdealers will be registered, some of which have never been registeredbefore.PiccolisaidtheCFTCwillworkwiththese entities to determine best practices and to develop testing methods the entities can understand.


Contact information

For more information about the topics covered at this event, contact one of our professionals:

Nichole JordanNational Banking and Securities LeaderGrant Thornton LLPT 212.624.5310E [email protected]

Jack KatzNational Managing PartnerFinancial Services Grant Thornton LLPT 212.542.9660E [email protected]

Visit www.GrantThornton.com/financialservices.

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