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Classic RIAs should expect little change but the SEC's ability to algorithmically raise more red flags may give it better ways to go after big dogs
March 14, 2016 — 11:17 PM UTC by Irwin Stein
Brooke’s Note: Pity the SEC in trying to keep track of all the gazillions of transactions on Wall Street both in their particulars and holistically. Since 2008, the embattled regulator has had seven years to try to develop countermeasures to the kinds of threats that stained its reputation. The SEC was largely blindsided by flash trading, the CDO crisis and was left holding the bag with Bernie Madoff, Allen Stanford. Each wrongdoer in those scandals essentially covered their tracks with the magic of the bull market. Irwin Stein, himself formerly a securities lawyer, takes on this topic and allows to me that it is indeed fairly difficult to divine whether anything is different under this new SEC unit — or whether it is even funded and near to what may have been conceptualized by the think tank that seems to have put it in motion. Still, he is sympathetic to the challenge today’s SEC faces.
The U.S. Securities and Exchange Commission is creating a new regulatory unit — with aspects of the Green Beret, Big Brother and Doppler radar — with the objective of avoiding the kind of blindsiding of investors the occurred in 2008-'09.
The big regulator announced the creation of the Office of Risk and Strategy last week to consolidate and streamline risk assessment, market surveillance and quantitative analysis teams.
But whether or not it amounts to a hill of beans is anything but clear.
What is certain is that the throughput of the markets is so colossal and that it moves with such rapidity in 2016 that the opportunity to pull fast ones is ripe.
Flash trading scandals and CDO crises are examples in the rarefied Wall Street world. Bernie Madoff and Allen Stanford are examples closer to investors themselves. See: One-Man Think Tank: The SEC’s custody examinations leave gaps big enough for Madoff to drive a bus through.
This elite SEC unit will be headed by Peter B. Driscoll under the title of chief risk and strategy officer. Driscoll, who formerly worked for Ernst & Young, will manage the new office and the investment advisor/investment company examination staff based in Washington, D.C. as part of the SEC’s Office of Compliance Inspections and Examinations (OCIE). See: Most RIAs prefer to pay money for SEC exams now than pay in blood later under an SRO.
The OCIE conducts the SEC’s national examination program through examinations of SEC-registered investment advisors, investment companies, broker-dealers, municipal advisors, self-regulatory organizations, clearing agencies and transfer agents.
But SEC Director Marc Wyatt, who hired Driscoll, uses the blandest terms in describing what Driscoll will do that isn’t already being done by the SEC.
“The Office of Risk and Strategy will lead our exam program’s risk-based, data-driven, and transparent approach to protecting investors,” Wyatt said in a release.
SEC Chair Mary Jo White noted in a recent speech that the new technology allows examiners to “access and systematically analyze massive amounts of trading data from firms in a fraction of the time it has taken in years past.” See: After starring in New Yorker article, Mary Jo White holds SIFMA event spellbound and 'no-admit, no-deny’ is still in play.
What is not likely to change one bit is the way that smaller RIAs are examined — or prosecuted, according to David Chase, former SEC prosecutor and new head of The Law Firm of David R. Chase P.A. , who said: “Enforcement cases will nonetheless be prepared the old-fashioned way by taking testimony and collecting documents,”
In an interview, he allowed that it is not easy to tell what this newly created aspect of the SEC portends.
But what the formation of the new office may signal is the SEC’s efforts to create a heat map or search tool to pinpoint where to direct its efforts — rather than on a scattershot approach. This capability is especially critical because the SEC is chronically underfunded, hence undermanned, an issue that arises again and again with regard to RIAs, especially in that RIAs typically get examined once a decade, if that. See: Recent SEC enforcement actions make annual policies and procedures exams even more important.
“They will probably be looking at illiquid investments, customer complaints, excessive transactions and those that employ significant leverage,” Chase says. “Analytics are a good way to identify red flags but there still may be good reasons for individual transactions.
One tangible result of this approach has been a recent report issued by the SEC staff identifying recidivist representatives with a history of misconduct. See: RIA advocates cry foul after international media pick up on U. of Chicago study labeling shady stock brokers as 'investment advisers’.
The staff has identified firms that hire individuals after they have been disciplined or barred from another broker-dealer. It intends to review the compliance systems at these firms to ensure that controls are in place to adequately supervise these individuals.
The Driscoll-headed unit follows the formation of the SEC’s Division of Risk, Strategy and Financial Innovation, the first new division in 37 years and the product of a think tank set in motion in 2009. It was renamed the Division of Economic and Risk Analysis in 2013.
Usual suspects get unusual scrutiny
The SEC oversees 12,000 investment advisors and examines about 10% to 12% percent of them, each year. The agency recently added 100 new examiners to its investment advisor exam staff by shifting examiners from its broker-dealer unit, bringing the total to 630. This reflects the growing number of registered investment advisors as the industry continues its shift from a commission based to fee-based model. See: How many RIAs are there? No, seriously, how many?.
Last week, the SEC announced that it was preparing to use this new tool as part of its annual examination program for all investment advisors. Specifically, it intends to use the data collected in these examinations to identify registrants that appear to have what it considers elevated risk profiles.
If all goes to plan, large and small RIAs and new products may be targeted; bad brokers identified.
Certainly this data will be used to examine large fund managers using algorithmic tools to enhance their trading. The same data analytics will also identify excessive or inappropriate trading at the individual registered representative level. It will also be used to detect micro-cap fraud, pump-and-dump schemes and market manipulation.
The examinations will also focus on the anti-money laundering regulations. This would include firms that have not filed the number of suspicious activity reports that would be consistent with their business models or have filed incomplete or late SARs. See: How a picture overshadowed thousands of words in the coverage of the 1999 Alex. Brown-Deutsche Bank-Holocaust bombshell and how it resonates still.
The Commission has always made a priority of reviewing individual sales practices. It can now focus on the promotion of new, complex and high risk-products. How those products are used and how they are represented to customers may become the basis for future enforcement actions.
An example might be collateralized mortgage obligations, which were often represented as less risky, specifically because they were collateralized. This data-driven approach might well include a consideration at where in the real estate cycle the representation of “less risky” is being made. See: Can the behavior of RIA clients be changed? Yes … but.
The Flash Crash of 2010 was the impetus for the SEC’s focus on developing efficient data collection and analytical tools that it is now using to enhance its annual audit and examination programs for broker-dealers, investment advisors and other registered market participants. The data analytic approach should lead to better market surveillance. The examination results may lead to enforcement actions and will also impact Commission policy decisions.
On May 6, 2010 the market crashed more than 1000 points in just five minutes followed by a full recovery 15 minutes later. It apparently took the SEC’s staff approximately four months to reconstruct and analyze the data to determine what had occurred. The final report analyzed thousands of stocks’ order books and required complex analytics to analyze billions of records to reconstruct the crash’s events.
Not wanting to replicate the effort should a similar crash happen in the future, the Commission turned to the private sector. The cost was reported at only $2.5 million and was ready within a year of the time that the contract was approved.
The result was the January 2013 rollout of the Market Information Data Analytics System (MIDAS), which collects more than one billion records per day from each of the 13 national equity exchanges, each time-stamped to the microsecond. The SEC now has access to data about every displayed order posted in the national exchanges in near real time. See: How leery RIAs should be of a flash crash and how much the SEC’s new report advances our understanding.
Trade data comes from consolidated public and proprietary feeds. MIDAS allows the SEC to monitor market activities as they happen. It is used by SEC staff across all divisions. It provides data for investigations, enforcement proceedings and the development of regulations and policy decisions.
MIDAS is cloud-based. Like the SEC’s EDGAR database of financial reporting information is accessible by the public. See: Review: What the SEC did right and wrong with the redesign of its website.
The website includes not just the data but interactive charting tools that allow users to analyze the data using 600 market metrics that the SEC staff also uses. This type of analytics may not be for everyone but the site has proved to be popular with serious investment professionals and academics.
MIDAS may be one of the reasons that the industry has added so many chief risk officers and additional tech support to their compliance staffs. It certainly adds a degree of transparency into the staff’s thought process, focus and concerns.
From theory to practice
MIDAS was an outgrowth of a focus that the Commission adopted after the financial crisis. In 2009 it created the new Division of Risk, Strategy and Financial Innovation, at the time its first new Division in 37 years. Renamed the Division of Economic and Risk Analysis in 2013, it was tasked with anticipating market problems.
This Division was the Commission’s internal think tank. The first head of the Division, Univ. of Texas Prof. Henry Hu, an expert on derivatives, was one of the few academics on the Commission’s senior staff. The new Division focused on common issues, such as high-risk products and high-risk entities that were of concern across the SEC’s mandate.
By 2013, the SEC had developed a National Exam Analytics Tool, which enabled examiners to access and systematically analyze massive amounts of trading data from firms in a fraction of the time it had taken in years past. See: The SEC’s unannounced compliance exams are growing more common. That means the 'I’ll-get-to-it’ strategy is an even worse idea than before..
What does all this mean?
Investment advisors and others in the industry have always known that the SEC was looking over their shoulder. Technology makes it easier for advisors to access more information about the markets to provide their clients with better advice. It should surprise no one that the SEC has adopted new technology to enhance its core missions of preserving the integrity of the markets and protecting investors.
What may sound like “big brother” to some may be nothing more than a government agency using technology to become more efficient and redirect its budget to get more done.
For further clarification the SEC has opened registration for its compliance outreach program’s national seminar for investment companies and investment advisers. The event is intended to help chief compliance officers and other senior personnel at investment companies and investment advisory firms to enhance their compliance programs for the protection of investors. See: Tom Bradley makes the case for regulatory efficiency — and maybe, FINRA, especially for the dually registered.
The national seminar will be held on April 19 at the SEC’s Washington, D.C., headquarters from 8:30 a.m. to 5:30 p.m. ET. In-person attendance is limited to 500; a live webcast will be available at www.sec.gov
Irwin Stein is a Wall Street trained securities attorney. He has represented broker-dealers, RIAs, traders and professional investors for more than 40 years.
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