SIFMA C&L Annual Seminar CLE Outline

Panel: MB: Electronic and Across Asset Classes Date/Time: Monday, March 16, 2020; 12:15PM - 1:30PM Moderator: Gary M. Rosen, Global Head of Markets and Securities Services Compliance, Citigroup Global Markets Inc. Panelists: Theodore R. Lazo, General Counsel and Head of Market Structure, BIDS Trading, L.P. Stephen Luparello, General Counsel, Citadel Securities LLC Maura Miller, Director - Equities Compliance, Credit Suisse Securities (USA) LLC Aileen Postlethwaite, Director, Electronic Trading, Markets Compliance, Barclays Laura S. Pruitt, Partner, Jones Day Topics: ● Trading Platforms and Venues—Alternative Trading Systems and Dark Pools ● Trading Controls and Governance—Roles and Responsibilities ● Use of Artificial Intelligence by the Front Office and Control Functions ● Market Structure Developments, including the SIP Proposal ● Focus Areas of Global Regulators

I. Trading Platforms and Venues

A. Form ATS-N

1. In July 2018, the Securities and Exchange Commission (“SEC’) adopted amendments to Regulation ATS intended to provide with more inclusive standardized and consistent information about “NMS Stock ATSs” (i.e., those that trade listed stocks) by requiring them to file detailed disclosures on Form ATS-N.1 Form ATS-N requires NMS Stock ATSs to disclose to the public for the first time, certain information about their operations, including descriptions of their fees, the trading activities by their broker-dealer operators and their affiliates in the ATS, their use of market data, their written standards for granting access to trading on the ATS, and their written safeguards and procedures for protecting their subscribers’ confidential trading information required by Rule 301(b)(10) of Regulation ATS.

2. NMS Stock ATSs that were already operating (“Legacy Stock ATSs”) were required to file an initial Form ATS-N in early 2019, with an expectation that they would be deemed effective by the SEC staff shortly thereafter. However, according to SEC extension orders for multiple Forms ATS-N, the initial Form ATS-N disclosures and discussions with Commission staff revealed complexities about the operations of Legacy NMS Stock ATSs including, among other things, matching functionalities, means of order entry, order interaction and execution procedures, conditional order processes, segmentation of orders, and counterparty selection protocols. As a result, SEC staff required additional time to review novel and complex issues with numerous NMS Stock ATSs.2

B. Boston Token Exchange

On December 18, 2019, The Boston Options Exchange (“BOX”), filed a proposed rule change with the SEC in connection with the proposed commencement of operations of the Boston Token Exchange

1 See SEC Release No. 34-83663 (Jul. 18, 2018). Rule 304 of Regulation ATS now requires an NMS Stock ATS to file with the SEC (through Edgar) an initial Form ATS-N that must become effective and contain public disclosures about the NMS Stock ATS. By contrast, Form ATS is confidential when filed. See Rule 301(b)(2)(vii) of Regulation ATS, 17 CFR 242.301(b)(2)(vii). 2 Form ATS-N filings can be found at: https://www.sec.gov/divisions/marketreg/form-ats-n-filings.htm. (“BSTX”) as a facility of the exchange to operate a market for the trading of digital security tokens.3 BSTX would operate a fully automated, price/time priority execution system for the trading of “security tokens,” which would be equity securities that meet BSTX listing standards and for which ancillary records of ownership would be able to be created and maintained using distributed ledger (or “blockchain”) technology. The security tokens would qualify as NMS stocks pursuant to Regulation NMS. All transactions in security tokens would clear and settle in accordance with the rules, policies and procedures of registered clearing agencies.

C. Fixed Income Trading Platforms

1. The SEC’s Technology and Electronic Trading Subcommittee of the Fixed Income Market Structure Advisory Committee is charged with considering the impact of the growth of electronic trading platforms and the increased use of other electronic systems on the liquidity, efficiency and resiliency of the corporate and municipal bond markets.4 On July 16, 2018, the Subcommittee submitted a recommendation for the SEC to review the framework for the oversight of electronic trading platforms for corporate and municipal bonds.5 Noting the disparity between the regulation of such platforms, the Subcommittee concluded that “[w]ithout a unifying regulatory framework for all fixed income electronic trading platforms, market structures will likely fragment further as regulators adopt new regulations that apply to only one type of platform.” Consequently, the Subcommittee recommended that the SEC, FINRA and MSRB form a joint working group to conduct a review of the regulatory framework for oversight of electronic trading platforms used in the corporate and municipal bond markets to plug regulatory gaps and promote consistent regulation.

2. Currently, platforms limiting their activities to solely effecting transactions in “government securities,” as that term is defined in Section 3(a)(42) of the Exchange Act, are not required to comply with the registration and other requirements of Regulation ATS.6 Because they are not ATSs, these platforms would not be subject to the capacity, integrity, and security requirements under Regulation ATS, nor would they be subject to Regulation SCI’s requirements for system capacity, integrity, resiliency, availability, and security. Some regulators have suggested that the SEC consider whether it should apply Regulation ATS to U.S. Treasury venues that fit within the definition of an ATS, as a means to

3 See BOX Exchange LLC; Notice of Filing of a Proposed Rule Change in Connection with the Proposed Commencement of Operations of Boston Security Token Exchange LLC as a Facility of the Exchange, SEC Release No. 34-87868; File No. SR-BOX-2019-37 (Dec. 30, 2019), https://www.sec.gov/rules/sro/box/2019/34-87868.pdf Previously, on March 7, 2018, the SEC’s Divisions of Enforcement and Trading and Markets issued a “Statement on Potentially Unlawful Online Platforms for Trading Digital Assets,” advising that, where the assets traded on these platforms are securities, these platforms may be operating as “exchanges” under the federal securities laws and be required to register as an exchange or ATS. 4 Information about the subcommittee and minutes of its meetings can be found at: https://www.sec.gov/spotlight/fixed-income-advisory-committee/fixed-income-market-structure-advisory- committee-subcommittees.htm. Topics that may be considered by the Subcommittee include methods to promote the use of, and access to, electronic platforms, consideration of standards for platforms concerning governance, transparency, resiliency, access, error resolutions, and data management. 5 See Recommendation for the SEC to Review the Framework for the Oversight of Electronic Trading Platforms for Corporate and Municipal Bonds (July 16, 2018), available at https://www.sec.gov/spotlight/fixed-income-advisory- committee/fimsac-electronic-trading-platforms-recommendation.pdf. 6 See Rule 301(a)(4) of Regulation ATS, 17 CFR 242.301(a). When Regulation ATS was originally adopted in 1998, it excluded these platforms from the Regulation because, while Treasury-only venues present regulatory considerations similar to those in the equities markets, the multiple layers of regulatory oversight of the U.S. Treasury market reduced the need for the SEC to apply Regulation ATS. See SEC Release No. 34-40760 (Dec. 8, 1998), 63 FR 70844, 70859 (Dec. 22, 1998).

2 strengthen the public markets for Treasury securities and to allow for fair access to such platforms, among other reasons.7

II. Trading Controls and Governance

A. Regulatory Exam Focus

In 2020, OCIE intends “to continue to examine for controls around the use of automated trading algorithms by broker-dealers. Algorithmic trading has expanded into multiple asset classes and is subject to SEC and FINRA rules governing trading activity. Poorly designed trading algorithms have the potential to adversely impact market and broker-dealer stability. OCIE will, therefore, examine how broker-dealers supervise algorithmic trading activities, including the development, testing, implementation, maintenance, and modification of the computer programs that support their automated trading activities and controls around access to computer code. Finally, OCIE will examine registered firms’ use of internal procedures, practices, and controls to manage trading risk.”8

B. Supervision and Control Practices

1. FINRA has previously published guidance on effective supervision and control practices for firms engaging in algorithmic trading practices, including high frequency trading. The practices highlighted by FINRA related to general risk assessment and response; software/code development and implementation; software testing and system validation; trading systems; and compliance.9

2. FINRA Rule 1220(b)(4)(A) provides that “each person associated with a member who is: (i) primarily responsible for the design, development or significant modification of an algorithmic trading strategy relating to equity, preferred or convertible debt securities; or (ii) responsible for the day-to-day supervision or direction of such activities shall be required to register with FINRA as a Securities Trader.”10

C. Market Access Rule Controls

1. Exchange Act Rule 15c3-511 requires a broker-dealer with market access, or that provides a customer (which includes other broker-dealers, individuals and institutions such as hedge funds, mutual funds, banks and insurance companies) or any other person with access to an exchange or ATS through use of its MPID or otherwise, to establish, document, and maintain a system of risk management controls and supervisory procedures reasonably designed to manage the financial, regulatory, and other risks, such as legal and operational risks, related to market access. In addition, these controls, with limited exceptions, must be under the direct and exclusive control of the broker-dealer providing market access.

7 See, e.g., remarks by SEC Commissioner Elad L. Roisman at the U.S. Treasury Market Conference (Sept. 23, 2019), available at: https://www.sec.gov/news/speech/roisman-2019-09-23. 8 See Office of Compliance Inspections and Examinations, 2020 Examination Priorities (hereafter, “OCIE 2020 Exam Priorities”), available at: https://www.sec.gov/about/offices/ocie/national-examination-program-priorities- 2020.pdf . 9 See FINRA Regulatory Notice 15-09 (March 2015). 10 See FINRA Regulatory Notice 16-21 (June 2016). 11 See 17 CFR §240.15c3-5. See also FINRA Rule 5210 and Supplementary Material .01, which prohibits firms from publishing any quote without having reasonable cause to believe that it is a bona fide quotation, is not fictitious and is not published or circulated for any fraudulent, deceptive or manipulative purpose, and Supplementary Material .03 to the Rule, which provides examples of activity that would present a “frequent pattern or practice” of prohibited quoting and trading activity. See also FINRA Regulatory Notice 17-22 (June 2017).

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2. In its report on its 2019 exam findings, FINRA noted that it continues to find issues relating to market access controls, including with respect to: pre-trade order limits, pre-set capital thresholds and duplicative and erroneous order controls, particularly for fixed income transactions; inaccurate intra-day adjustments to credit limits; ineffective trading controls (e.g., setting controls at unreasonable levels, preventing firms from blocking erroneous trades); and insufficient post-trade controls and surveillance.12 In fact, both FINRA and OCIE have included direct market access controls as priorities for examination in 2020.13 Among the things they will be reviewing are firms’ controls around systems’ changes, controls to monitor and respond to aberrant behavior by algorithms, processes around changes to credit limits (particularly intra-day), and use of third-party vendor tools for market access rule compliance.

III. Use of Artificial Intelligence (“AI”)

According to OCIE’s 2020 Examination Priorities, OCIE examinations will focus on firms’ use of “alternative data” sets and technologies to interact with and provide services to investors, firms, and other service providers and assess the effectiveness of related compliance and control functions.14

A. Trading Applications

1. Many market participants are expanding their use of AI in connection with their trading activity. AI allows firms to analyze millions of data points in real time and capture information that many statistical models cannot. AI can be used to predict stock performance, such as through pattern recognition technology, analyze potential trades and create and handle orders.15

2. AI can also create issues that need to be managed. For instance, use of AI can make the basis for a particular decision difficult to ascertain, since communications inside AI systems are not transparent. Where an AI system is responsible for problems that arise through trades from the system, firms should consider who is responsible for the AI system. Because AI outputs are based on inputs, where multiple market participants experience rapid losses over a short period of time, for example, AI can increase market , thereby creating systematic risk. Likewise, because of the lack of existing data regarding crises, AI systems are limited in their ability to function when the markets are in crisis, necessitating human intervention.

B. Use of AI in Surveillance/Compliance

1. AI can be used to, among other things, assist firms with AML compliance, fraud prevention, employee conduct surveillance, and risk management. It can reduce compliance system false positives and cut down on human error.

2. While AI and other automated systems can enhance and complement a firm’s supervisory systems, they cannot, however, replace individual supervisors. FINRA Rule 3110 requires that a broker-dealer supervisory system, at a minimum, designate appropriately registered principals to carry out the supervisory responsibilities of the firm for each type of business in which it engages for which

12 See FINRA’s October 2019 Report on FINRA Examination Findings and Observations (October 16, 2019), available at: https://www.finra.org/rules-guidance/guidance/reports/2019-report-exam-findings-and-observations. 13 See, respectively, OCIE 2020 Exam Priorities, supra, n. 6, and FINRA’s 2020 Risk Monitoring and Examination Priorities Letter (January 2020), available at: https://www.finra.org/rules-guidance/communications-firms/2020- risk-monitoring-and-examination-priorities-letter. 14 OCIE 2020 Exam Priorities, supra, n. 6, at 14. 15 See, e.g., Thomas, M., “How AI Trading Technology is Making Stock Market Investors Smarter – and Richer” (Dec. 17, 2019), available at https://builtin.com/artificial-intelligence/ai-trading-stock-market-tech.

4 registration as a broker-dealer is required, and to assign each registered person to an appropriately registered representative(s) or principal(s) who shall be responsible for supervising that person's activities.

IV. Market Structure Developments

A. Access Fee Pilot

On December 19, 2018, the Commission approved Rule 610T of Regulation NMS to conduct a Transaction Fee Pilot in NMS stocks.16 The Rule contains two test groups of 730 NMS stocks each: (1) a no rebates group; and (2) a group with an access fee cap of $0.0010. After several exchanges filed lawsuits against the SEC, the SEC issued a Partial Stay Order, dated March 28, 2019, providing that, pending a decision by the Court of Appeals regarding the petitions to review Rule 610T’s validity and further order of the Commission, the suing exchanges will not be required to transmit order routing data to the Commission, or to publicly post Exchange Transaction Fee Summaries pursuant to the Rule. Nevertheless, the SEC issued an order in May 2019 requiring exchanges to start collecting data on how brokers route stock orders to the exchanges for the period July 1 - Dec. 31, 2019 (the pre-pilot period), which data will be used as a baseline if the pilot program resumes.17

B. Market Data and SIP Infrastructure

On January 8, 2020, the SEC published for comment a notice of proposed order that would modernize the governance of National Market System (NMS) plans that produce public consolidated equity market data and disseminate trade and quote data from trading venues.18 The proposed order directs the equities exchanges and FINRA to file with the SEC a new NMS plan designed to increase transparency and address conflicts of interest and other issues presented by the current governance structure of the existing NMS plans.

C. SEC Statement on Thinly Traded Securities

On October 17, 2019, the SEC issued a Statement on Market Structure Innovation for Thinly Traded Securities, seeking proposals that will improve secondary market trading for equity securities that trade in lower volume. The SEC explicitly noted its interest in considering proposals that could include the suspension or termination of unlisted trading privileges and/or exemptive relief from Regulation NMS and other Exchange Act rules.19

V. Focus Areas of Global Regulators

A. Prudential Regulatory Authority of the Bank of England (“PRA”) and the Financial Conduct Authority (“FCA”)

1. The PRA was established to regulate financial institutions, including banks and insurance companies, in response to the financial crisis of 2007. In 2013, the Financial Services Authority – the previous regulator – disbanded and the PRA and the FCA were created.

16 See Sec Release No. 34-84875 (Dec. 19, 2018). 17 See SEC Release No. 34-85906 (May 21, 2019), available at https://www.sec.gov/rules/other/2019/34-85906.pdf 18 See SEC Release No. 34-87906; File No. 4-757 (Jan. 8, 2020), at: https://www.sec.gov/rules/sro/nms/2020/34- 87906.pdf. 19 https://www.sec.gov/rules/policy/2019/34-87327.pdf.

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2. In June 2018, the PRA published a Supervisory Statement on Algorithmic Trading, setting forth a number of expectations regarding a firm’s governance and risk management of algorithmic trading.20

3. Likewise, on February 12, 2018, the FCA published a report on algorithmic trading compliance in wholesale markets, identifying five key areas of focus and describing both good and bad practices in each of those areas.21

B. MiFID II

The Markets in Financial Instruments Directive II (“MiFID II”), which, among other things introduced a number of requirements for firms engaged in algorithmic trading, was implemented on January 3, 2018.22 MiFID II requirements include, among others, (a) ensuring effective systems and controls, in particular to ensure its trading systems are resilient, to maintain trading thresholds and limits, to prevent incorrect orders contributing to a disorderly market and, to prevent breeches of applicable regulations or the rules of a trading system; (b) systems must be fully tested before deployment and deployed or substantially updated only on the authority of a senior management designate and only where there are predefined trading limits; and (c) firms must maintain defined pre-trade controls on order entry, monitor all trading activity under its trading code on a real-time basis, and continuously operate post-trade controls, including of its market and credit risk. Firms also must notify the regulator of any EU trading venue on which it engages in algorithmic trading, as well as its own regulator.

C. Hong Kong’s Securities and Futures Commission (SFC)

1. Since December 1, 2015, retail investors have been banned by the SFC from dark pool trading platforms, such that only fund managers and experienced traders are permitted to trade on Hong Kong’s dark pools.23

2. In 2016, the SFC published a Circular to provide firms with guidance with respect to controls surrounding their algorithmic trading systems to ensure that their trading activities will not pose undue risks to the market.24 Highlighted areas for improvement included insufficient pre-trade controls to prevent the generation of algorithmic orders which might adversely affect market integrity and inadequate due diligence on algorithmic trading systems provided by third party service providers.

20 See Bank of England Prudential Regulation Authority, Supervisory Statement SS5/18, “Algorithmic trading” (June 2018). This Supervisory Statement was originally published for comment on February 12, 2018. 21 See Financial Conduct Authority, Algorithmic Trading Compliance in Wholesale Markets (February 2018). The five areas are: defining algorithmic trading; development and testing; risk controls; governance and oversight; and market conduct. 22 See Directive 2014/65/EU of the European Parliament and of the Council of 15 May 2014 on markets in financial instruments and amending the Insurance Mediation Directive and AIFMD, as supplemented by Commission Delegated Regulation (EU) 2017/589 (25 April 2016). 23 See https://www.scmp/print/business/markets/article/1799052/hong-kongs-sfc-bans-retail-investors-dark-pool- trading-platforms. 24 See SFC Circular to all Licensed Corporations on Algorithmic Trading (Dec. 13, 2016), SFO/IS/044/2016.

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