A rule proposed by the Financial Industry Regulatory Authority that could limit broker-dealers’ usage of indications of interest drew mixed reviews from those who submitted comment letters to the regulator this month.
Brokers and their advocates shot down the proposal, while one major buyside shop praised FINRA. While respondees differed on the rule’s impact on buyside-sellside relations, both sides managed to find some common ground.
"The STA is opposed to this amendment," James Toes, president and chief executive of the Security Traders Association, told FINRA in its letter. "Rather than clearing up a perceived issue emanating from a small subset of the marketplace, this amendment would build a wall between market participants."
In favor of the change was Capital Research and Management Company, a large money manager based in Los Angeles. Saying he supported the "broad intent" of the rule, Matt Lyons, the firm’s global trading manager urged FINRA to fine-tune it. Capital Research "applauds the ongoing work of FINRA to improving the quality and clarity between member firms and their customers," Lyons said.
At issue is a proposed amendment to FINRA’s Rule 5210, published last month, that attempts to bar brokers from sending out IOIs labeled as "natural" if they aren’t backed by an actual customer order.
In its proposal, FINRA said it was concerned that brokers were disseminating misleading information regarding IOIs, including not accurately labeling them to reflect their origination.
The proposal addresses buyside complaints that some of the IOIs they receive are mislabeled. They’re called "naturals," but, in fact, are not associated with an actual order. There may be no order or the "order" may, in fact, be a broker’s proprietary position.
The proposal is the third time in the past five years that FINRA has addressed the problem. In both September 2006 and May 2009, FINRA (or predecessor NASD) sent out notices to its members reminding them to be "truthful" when using IOIs.
The recent warning was apparently not enough for some.
"While we believe the 2009 notice was helpful, we received a number of comments from our committees and otherwise that without a clear definition of a natural IOI, there is still potential for misuse," Rick Ketchum, FINRA’s president and chief executive officer, said at a recent industry conference. "Namely, when the buyside trader attempts to reach out to a natural IOI, he finds there is no longer any trading interest behind it."
Most IOIs are not labeled as "naturals," according to a vendor who distributes the trade advertisements for brokers. "Many broker-dealer firms disseminate hundreds of thousands of IOIs daily while marking only a few hundred or less as natural IOIs," Raptor Trading Systems’ Nasser Sharara told FINRA.
Still, those that are labeled natural get the buyside’s attention. "Many buyside traders consider the non-natural IOIs as noise and ignore them," Nasser explained. "They only view the natural IOIs."
In their letters, the brokers called FINRA’s proposal a bad idea. They argued they sometimes received verbal instructions-but not actual orders- from their customers to send out IOIs on their behalf. They told FINRA that communique should suffice.
Brokers also pointed out that some of the so-called natural IOIs they send out are based on previous conversations with their customers. They often label these IOIs as ITWs, or "In Touch Withs."
Toes, citing concerns from STA’s buyside members, said the requirement would impede money managers’ search for liquidity and "compromise the relationship between a broker-dealer and a client."
Whichever side they took, some of the respondees suggested that fine-tuning the labeling of IOIs was warranted. JMP Securities, for instance, recommends stratifying natural IOIs into three groups: those with associated orders; those based on verbal communications; and those based on past conversations-the "In Touch Withs."
Lyons, of Capital Research, suggests that FINRA add two more categories: "principal" IOIs, for those times when a broker is looking to unwind a position, and "In Touch With" IOIs. Some brokers already label their IOIs as "In Touch Withs," but not all, Lyons noted.
Speaking at this year’s Security Traders Association conference in Palm Beach, Ketchum said FINRA was divided over the need to regulate IOIs. "We really do want comments on [the proposal]," Ketchum said.
"Even within FINRA there is a debate as to the appropriateness of how to handle this issue. We’re not interested in putting another rule in place that’s just a trap for the unwary. We are not interested in changing the way order handling operates. We are interested in working with you to try and ensure a level of confidence that there is not a conscious effort to mislead investors."
