Nasdaq desks are increasingly burdened by new trading rules and other market developments. Sometimes, traders do not fully understand their obligations.
Remarkably, however, market makers are now hiring independent compliance consultants and using their own compliance staffers, rather than turning to the National Association of Securities Dealers for support.
Yet, less than two years ago, a sense of cooperation existed between the NASD and its member firms. Compliance was often an afterthought. Penalties for trade violations frequently were limited to slaps on the wrist. Alas, the partnership has given way to animosity and mistrust. And one reason for the dramatic change is economics.
Trading profits were once king, and little else mattered. In 1997, with implementation of the Securities and Exchange Commission-approved order handling rules, and the switch to trading stocks in sixteenths, spreads narrowed dramatically. NASD fines and sanctions for market-making activities, which can range from $5,000 to $100,000, were no longer just another cost of doing business.
A second reason is that traders simply lost faith in the NASD. Traders rely on instincts, and their instincts tell them the NASD is too hostile to broker dealers in general, and to market makers in particular.
Throughout 1997, trading desks were repeatedly burdened by the NASD's stepped-up surveillance program that featured unprecedented numbers of examinations, reviews, inquiries and market sweeps.
Oftentimes, firms concurrently fielded as many as three of these reviews. Trading had to be disrupted as head traders retreated to back rooms to investigate possible trade violations, some going back to early 1996. The NASD's findings usually led to accusations of late trade reporting, backing away and quote violations, and concluded with fines and sanctions. It was not uncommon for the NASD to assess a $20,000 fine for two or three violations in a test universe of 40,000 trades.
Above all, traders are practical people. While trading in the present, they are mindful of the future. Looking ahead, market makers realize that regulatory compliance is likely to get worse before it begins to get better. New rules and trade-processing developments have been proposed. Last year's order handling rules continue to be difficult to implement. The regulators have new priorities.
Compounding these issues, market makers have fewer places to turn for help. Lines of communication with the NASD have been effectively cut off. Meanwhile, assistance among trading desks is not practicable because traders on these desks are riled about backing-away charges they have leveled against each other.
To be sure, life at the NASD in 1997 was no bed of roses. The association was severely sanctioned by the SEC in August 1996 for not having adequately controlled the activities of its member firms, that in turn were accused by the SEC of abusive practices to suppress competition and mislead customers. The NASD, through its NASD Regulation (NASDR) subsidiary, fought back. NASDR adopted an aggressive and adversarial posture that featured by-the-rule-book surveillance techniques and zero tolerance for trade-rule violations, intentional or not.
All the while, the NASD busily implemented a restructured governance and organization that was largely influenced by the SEC. Association staff members, many of whom were relatively inexperienced, sorted through the same new trading rules that confronted and confounded traders. Even now, examiners, analysts and attorneys in NASD Market Regulation, District 10 and other district offices are moving en masse to the dealer side, lured by attractive compensations.
Nevertheless, by year-end, NASDR had amassed an extraordinary record of disciplinary actions against its member firms and their associated persons. The regulator's downside may be that while the NASD is winning the battles with its member firms, it is losing the war.
Mindful of these issues, every trading desk should begin to develop an effective compliance strategy. A trader's first step should be to gain a better understanding of trade compliance. What is driving the NASD's efforts? What are the key rules and issues? Who is out there to help? What should broker dealers and the NASD be doing? Think of these exercises as needs analysis for reinforcing trade-rule compliance and for renewing relations between the NASD and its member firms [see sidebar above].
First of two-part series.
Next month: Compliance checklist and other matters.
Howard L. Haykin, CPA, is president of Compliance Solutions, a New York-based specialist in regulatory compliance for broker dealers and investment advisers.
