Finra’s proposed monitoring system could cost industry millions

An automated data collection system that would allow Finra to improve its monitoring of brokerage firm customer accounts would require new and potentially costly coordination between brokers and clearinghouses, according to industry participants.
On Dec. 23, the Financial Industry Regulatory Authority Inc. released a request for comment on a proposal called the Comprehensive Automated Risk Data System. Under the program, Finra would compile account activity information that firms currently maintain in their books and records. The regulator said that the system would allow it to identify harmful sales practices more quickly and efficiently than it does now.
But the system would present a data collection challenge because account information, such as investor profiles and investment objectives, may be maintained in different ways by individual brokerages and clearinghouses. Making the process uniform would require either the brokers to standardize their profiles or the clearinghouses to set up data protocols that are adopted by the industry, according to Paul Tolley, chief compliance officer at Commonwealth Financial Network.
“In order for Finra to articulate this system, there have to be uniform definitions,” Mr. Tolley said. “There may be a substantial cost associated with that either on the B-D side or on the clearinghouse side, depending on which way they go.”
Steven Wallman, chief executive of Foliofn Inc., a clearinghouse and custody firm, said that the data points that Finra could seek are either not captured by both broker-dealers and clearinghouses or are maintained in unique ways on both sides. Standardization could be complicated.
“There’s an added level of coordination that is problematic and always more costly,” Mr. Wallman said.
The proposed data collection requirements also could force clearinghouses to collate and manage reams of new account information from brokers.
“Now you’re in the data warehousing and data collection business — that’s not the business we’re in,” Mr. Wallman said.
In the regulatory notice, Finra noted that clearing firms would incur costs related to building and maintaining the technology to provide account information to the regulator, while brokerages would have expenses related to providing additional information to clearing companies.
Finra officials were not available for comment.
The regulator said that the system, which has not yet been formally proposed as a new rule, would allow Finra to perform more-sophisticated data analysis of industry practices that could harm investors.
“The information collected through CARDS will allow Finra to run analytics that identify potential ‘red flags’ of sales practice misconduct and help us identify potential business conduct problems with firms, branches and registered representatives,” Susan Axelrod, Finra executive vice president of regulatory operations, said in a statement.
The system will help the broker-dealer regulator ferret out “churning, excessive commissions, pump-and-dump schemes, markups [and] mutual fund switching,” among other sales violations, according to a regulatory notice.
Brokerage firms would have to provide the account information to their clearing firms — from which Finra would obtain it. Finra would seek account types and categories, customer investment profiles, purchase and sales transactions, additions and withdrawals, margin and balances and a description of securities, among other data.
The information collected in the initial phase of the program is similar to what Finra currently culls on a firm-by-firm basis during examinations. Retrieving it through the new system prior to exams would help Finra identify investor risks earlier, according to a Finra statement.
Amy Lynch, president of FrontLine Compliance, said that while the initiative could be a boon to Finra, it likely will draw initial resistance from financial firms.
“It’s going to be a huge burden, especially on the clearing firms, initially, to implement the technology,” Ms. Lynch said, adding that industrywide costs will be at least in the millions of dollars. On an individual-firm basis, she said it would be hard to estimate.
The system “would have to be scalable, somehow,” Ms. Lynch said. “Think of all the firms that don’t have the resources to implement the new required technology.”
Finra released the request for comment in part to get industry feedback for a cost-benefit analysis of an information-collection system. The regulatory notice didn’t contain cost estimates, but Finra said the program would ease regulatory hassles by making the examination process more efficient.
“CARDS is intended to reduce burdens on firms by eliminating intermittent information requests from Finra for the information CARDS covers,” according to the notice.
Mr. Wallman said that the system could provide a more efficient way to collect account information than the current process of gathering it firm by firm.
“I applaud their looking at it as a new way of doing oversight and regulation,” said Mr. Wallman, a former Securities and Exchange Commission member. “It’s exactly the kind of thing as a regulator I would do.”
Mr. Tolley similarly endorsement the concept.
“Overall, I’m in favor of the nature of the proposal,” Mr. Tolley said. “[But] there are complexities involved.”
Among those complexities would be the need for the clearing firms and brokerages to add another level of coordination.
“There could be heated discussions as to who is responsible for which end of the data,” Ms. Lynch said.
Finra would collect the information on a daily or weekly basis from clearing firms and perform data analysis to get a better handle on customer contacts at individual firms as well as industry trends.
In a test of the concept using information from an individual firm and two clearing firms, Finra said it was able to pinpoint potential investor harm.
“For example, the analytics showed Finra that a firm was selling a new, high-risk product — a business in which the firm was not historically engaged and its financial reporting did not disclose,” the regulatory notice stated.