Officials at the National Association of Securities Dealers recently applauded Nasdaq traders for their improved compliance practices. Late trade reporting had declined by 13 percent in a nearly two-year period beginning August 1996, and Nasdaq traders were missing only half of one percent of all SelectNet liability orders.
Interestingly, the NASD largely attributes this turnaround to its Trading and Market Making Surveillance Examinations, or TAMMS exams.
TAMMS Evolution
TAMMS exams were initiated by the NASD in 1996, shortly after the Securities and Exchange Commission issued its Section 21(a) Report, which criticized the NASD for failing to police market makers.
In 1997, the NASD's Market Regulation unit conducted TAMMS exams on 110 of the largest over-the-counter market makers, collectively covering more than 90 percent of Nasdaq and the OTC markets. The staff found patterns of confused reporting practices, failed best executions and deficient supervisory practices.
The NASD imposed sanctions and collected significant fines. Compliance consciousness was raised, and the news on the Street was that the NASD was taking no prisoners.
This year, buoyed by its earlier successes, the NASD has expanded TAMMS exams for all market makers, from the smallest to the largest. NASD Market Regulation will continue to examine the largest market makers. District offices, under the direction of NASD Market Regulation, will perform all other TAMMS exams, concurrent with routine examination schedules.
TAMMS Focus
TAMMS exams are essentially audits of market-making practices and activities. They are intensive, high-powered and controlled by NASD Market Regulation. By contrast, less comprehensive, routine examinations are performed at the NASD district levels, covering general brokerage activities.
TAMMS exams touch upon just about every significant trading and order-handling rule.
Key areas are:
* Automated Confirmation Transaction reporting, or ACT, at the heart of NASD surveillance. Topics include the accuracy of reporting and the use of the .SLD modifier for late trades.
* Customer order handling in the areas of best execution, timely execution of limit orders, auto-routing and execution systems.
* Firm-quote obligations. Topics include backing away, failure to display customer limit orders and orders broadcast on SelectNet.
* 21(a) Report issues such as pricing and size conventions.
* Confirmation of transactions, including full disclosure in compliance with SEC Rule 10b 10.
* Written supervisory procedures and evidence of supervisory reviews.
* Books and records, including missing or inaccurate trading records.
TAMMS Process
TAMMS exams typically start with an announcement letter and end with a letter of sanction. In between, TAMMS examiners are likely to spend two weeks in the field and several months in their home offices during the examinations.
They review hundreds of market-making and customer transactions, and frequently expand their testing, sometimes to levels that border on harassment. Nasdaq trading and market data are also reviewed extensively. Significantly, very little time is spent with the trading desk and key firm personnel.
The examination phase concludes with an exit interview that clearly reflects the NASD's desire to reject compromise and embrace strict interpretations of rules. The Exit Conference Summary Form, with accompanying exhibits, outlines every aspect of the TAMMS exam, and can exceed 20 pages.
Each Nasdaq market maker then has an opportunity to respond. The challenge is to demonstrate that trading-desk activities, as a whole, do not constitute a pattern of rule violations. The NASD has, at least on record, promised to concentrate more on patterns of sanctionable events and less on individual or isolated violations.
To avoid sanctions, market makers must chip away at each and every apparent violation cited by the NASD. Many of the NASD's findings are questionable at best, and reflect the staff's relative inexperience with traders and the trading environment.
Indeed, head traders should help NASD staff understand that in many instances, violations did not occur, or that ambiguous NASD rules were applied. Alternatively, NASD staff should be informed that erroneous assertions of trading practices are being levelled against the desk.
For example, it would be worthwhile explaining to TAMMS examiners that a market maker that gave a print, minutes after receiving a SelectNet liability order, had not backed away from a firm quote.
NASD Assessment
Based on its assessment of the staff's initial findings and any market-maker responses, NASD Market Regulation may propose fines, sanctions and remedial actions. It is anticipated, although not certain, that the next range of sanctions will include individual traders, head traders and supervisory personnel.
Looking forward, Nasdaq market makers that have completed exit interviews should defend their traders and trade practices until the very end. Persistence may dramatically reduce fines and sanctions. Firms that have not yet been visited should prepare for TAMMS exams.
Head traders should emphasize to all Nasdaq traders and principals the importance of TAMMS exams. Traders should assist in the investigation of NASD findings, and, where applicable, be held accountable for errors that result in rule violations.
Howard L Haykin, CPA, is president of Compliance Solutions, a New York-based specialist in regulatory compliance for NASD broker dealers and SEC investment advisers.
