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Non-compliance with SEC Regulation SCI

by InnReg on January 29, 2022

Non-compliance with the Securities and Exchange Commission regulations, such as Regulation SCI or any other, is no small matter (Regulation SCI stands for Regulation Systems and Compliance Integrity).

The cumulative fines that the securities regulator levied in 2021 alone amounted to almost USD 4 billion. Additionally, with the recent surge in SEC activity in the last few years and the increased attention the SEC has been paying to the fintech industry – caution is most advised.

Crucially, however, it is of the utmost importance to know which regulation applies to you and your business. Just recently, an inter-dealer broker, a company called Dealerweb, had to settle charges made by the Financial Industry Regulatory Authority for failing to determine that its alternative trading system was subject to the SEC Regulation SCI.

In an effort to stay ahead of the curve, we have taken a deeper dive into SEC Regulation SCI to see how it plays with alternative trading systems (ATS). Ensuring proper compliance and integrity of business with SEC Regulation SCI, which can stand to be murky at times, could just prove to be the bleeding edge advantage your company needs.

Non Compliance Pitfalls SEC Regulation SCI and ATS Rules

Compliance and Integrity 

Lately, the markets have started becoming increasingly aware of the importance of compliance and integrity and the way they go hand in hand, especially in the financial sector and within fintech companies.Indeed, risks of not being compliant with rules and regulations that govern one's business have ushered in a new era of corporate operations and decision-making.

With the increased awareness of compliance importance, companies across all sectors have begun appointing dedicated managers or even C-level executives to handle this very area. Chief Compliance Officers, General Counsels, and legal professionals, in general, are being brought in at the inception stage to weigh in on important business decisions. No wonder, seeing as how performing regulatory checks and ensuring compliance and integrity leads to increased operational effectiveness and provides a key strategic advantage over competitors who are not as cautious.

This is especially the case within the financial industry, where government agencies and regulators take utmost care to ensure and enforce consumer protection and fraud reduction. Innovative new business models, such as those employed by fintechs, ought to be on the lookout even more – given the vastness of terra incognita in which they usually operate and seek growth.

When modernized and properly maintained, robust regulatory compliance programs could help a company locate fresh sources of revenue and detect growth opportunities more easily. All of this, of course, ultimately results in competitive advantages.

So, let’s take a look at Regulation SCI and what it represents.


Non Compliance Pitfalls - Regulation SCI

Non-compliance, of course, is a very obvious issue. Notwithstanding the vastness of that claim, it’s critical to be aware, before any work is done, which rules and regulations a company ought to be compliant with.

Regulation SCI is an abbreviation for “Regulation Systems and Compliance Integrity.” The Securities and Exchange Commission adopted both it and Form SCI in November of 2014 to strengthen the technology infrastructure of the securities markets. According to the SEC, the rules set out in Regulation SCI is there to, primarily:

  • Reduce the occurrence of IT and other technical systems issues
  • Improve business resiliency in the cases when systems problems do occur
  • Enhance the SEC’s oversight and enforcement of securities market technology infrastructure.

Regulation SCI applies to what the Commission refers to as “SCI Entities.” This includes, among others, alternative trading systems, or ATS.


The Ambit of Regulation SCI

The Regulation applies, mainly, to SCI entity’s systems that provide direct support of any of the following six securities market functions:

  • Trading
  • Clearance and settlement
  • Order routing
  • Market data
  • Market regulation
  • Market surveillance

Non-compliance with Regulation SCI carries a lot of weight. Penalty violations ordered by the SEC ranged in the millions, including a USD 1.5 million fine to ATS operator Virtu Americas for non-compliant practices with respect to trading volumes and a massive USD 14 million fine to the New York Stock Exchange for a number of “disruptive market events.

Still, a much larger issue is a situation in which the company is not aware that it is liable to conform to Regulation SCI. A more recent example of this is Dealerweb – the aforementioned inter-dealer broker – which was a victim of misinterpretation.


The Dealerweb Case - Misinterpretation Offers no Salvation

Dealerweb was forced to settle FINRA charges to the tune of a quarter of a million dollars after being found in breach of Regulation SCI for failing to properly determine – that its ATS system was subject to the Regulation. The company incorrectly performed certain calculations – applying wrong averaged data – and ended up in the red. From that point on, Dealerweb found itself in breach of several Regulation SCI provisions and had to agree to censure, in addition to the fine.

Seeing as how Dealerweb paid for its mistake dearly, it is important to also take a closer look at alternative trading systems.


ATS Rules

ATS rules are, to put it mildly, interesting. An alternative trading system is more loosely regulated than an exchange and is often used to match large buy/sell orders in order to provide alternative means of acquiring liquidity. They are sometimes called ‘cross networks’ or ‘call networks’ – in Europe, an ATS is called an MTF (multilateral trading facilities).


ATS Regulation is Broker-Dealer Regulation

Most ATS are registered as broker-dealers, and they do not set any rules that would govern the conduct of subscribers. ATS do not purport to regulate or discipline their subscribers, other than via excluding them from trading.

The main upside of this system is that using ATS to execute trades has the potential to reduce cascade effects that large trades might have on equity prices. Potential domino effects are stymied due to the fact that ATS transactions do not appear on national exchange order books.

The popularity of ATS can be seen in the fact that, between 2013 and 2015, about 18% of all stock trading was performed in that way, according to the SEC. This number represented an increase of more than 400% compared to 2005.

On the flipside, ATS trading venues must have SEC approval. Enforcement actions seeking to curb infractions like trading against the customer order flow or misusing confidential trading information were more frequent. This was ostensibly the case because the regulators have more fear of potential wrongdoing occurring, seeing as how ATS faces fewer regulations.


Specific ATS Regulatory Rules to Take Special Note of

The SEC established the regulatory framework for ATS with the SEC Regulation ATS. Even though an ATS does meet the definition of an exchange, there is no requirement for it to register as such if it operates under the Exchange Act Rule 3a1-1(a) exemption. To achieve this, the ATS must comply with the requirements set out in Rules 300-303 of Regulation ATS.

Additionally, to achieve compliance and integrity with Regulation ATS, the ATS must be registered as a broker-dealer. Also, the ATS must have filed an initial operation report on Form ATS with the SEC before beginning operations. Any amendments to Form ATS must be filed, and notice must be given in case of amendments to its operations. Finally, should an ATS cease operations, that should be filed on Form ATS as well. Filing requirements, which do include reporting of books and records, can be found in Rule 301(b)(2) of Regulation ATS.


How Best to Approach Regulation SCI and SEC Regulatory Structures

Given the intricate web of general financial legislation framework and the specific issues that Regulation SCI poses, maintaining high levels of compliance and integrity of operations is strongly advised – not to mention if your business is a fintech company or if you operate and manage an ATS.

In addition to staving away potential harms to your corporate operations and overall business model integrity, running a tight ship compliance-wise can lead to other benefits. Staying ahead of the regulatory curve and investing in expertly designed and deployed compliance policies could also elevate your market position ahead of that of your competitors.

However, this is much easier said than done, all the more so due to the occasional vagueness of regulatory rules and slow-moving regulatory bodies. But, there are ways in which compliance could be achieved faster and maintained in a less taxing manner – calling in the experts.

Partnering with an external expert to create a bespoke compliance solution, like InnReg, makes for a happier business operation. Opting for this path allows you to drive corporate operations in the direction of maximum revenue and profit maximization, all the while minimizing costs.

InnReg has a deep understanding of what challenges and distinct obstacles ATS platforms face. Digital trading technology usage and multiple regulatory clearances and approvals are but a first step. This system must operate with complete accuracy when onboarding and approving client accounts, managing online funds transfers, matching buy and sell orders, and settling transactions.

At InnReg, ATS programs are supported in three critical areas:

  • Regulatory Structure. Determination of the best regulatory structure based on your business model, technology, and customer acquisition strategy; afterward, allowing for the unique aspects of your business to acquire relevant regulatory approval - before the SEC and FINRA
  • Compliance Workflows. Development and maintenance of compliance and operational workflows to complete, among others, the customer onboarding processes, trading surveillance, and regulatory reporting in an optimal way
  • Outsourced Compliance Team. Taking ownership of the compliance and back-office operational flows on a completely outsourced basis, thus enabling you to focus on growth and expansion

Even in the case in which you feel that immediate outsourcing is a step too far, at least initially, InnReg can still help. InnReg, in addition to the ability to leverage your existing platform, can also recommend best-in-line technology solutions to fulfill all of your compliance and integrity, as well as back-office needs.

The final recommendation will, in any case, integrate proven third-party solutions into your proprietary structures to achieve peak results. All systems and data banks are cloud-based, so your team would have easy access at all times and from all locations.

Topics: Compliance Risk



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