Use of Trading Schemes

The exam word for these is schemes. The rulebook splits them across a statute that punishes the manipulative purpose and a FINRA rule that describes the trading pattern itself.

What Makes Prearranged Trading Manipulative?

The statutory manipulation prohibition describes this conduct in three lettered acts, which fall into two shapes. All three sit under one purpose clause: creating a false or misleading appearance of active trading in a security other than a government security, or a false or misleading appearance with respect to the market for it.

The acts bind any person acting directly or indirectly by the use of the mails, any means or instrumentality of interstate commerce, or any facility of a national securities exchange, and separately any member of a national securities exchange.

• The wash sale. Effecting a transaction in the security which involves no change in the beneficial ownership of it.
• The matched order. Entering an order to purchase the security with knowledge that an order or orders of substantially the same size, at substantially the same time, and at substantially the same price to sell has been or will be entered. The mirror image, an order to sell entered with knowledge of a matching purchase order, is stated separately.

The statute adds that those matching orders may be entered by or for the same or different parties, so two coordinated firms are described as squarely as one account trading with itself.

Exam Tip: Gotchas

• The purpose clause is what makes the trade manipulative. Without the purpose of creating a false or misleading appearance of active trading, or of the market, the described acts are not this provision's conduct.
• Government securities sit outside this particular provision. The false-appearance acts are written against a security other than a government security.
• Matched orders need only substantial similarity. The test is substantially the same size, time and price, not an exact match on any of the three.

When Is a Self-Trade Bona Fide?

The publication of transactions and quotations rule addresses the firm-internal version. Self-trades are transactions in a security resulting from the unintentional interaction of orders originating from the same firm that involve no change in the beneficial ownership of the security. They generally are bona fide transactions for purposes of that rule.

The word "however" then adds a duty. Members must have policies and procedures in place that are reasonably designed to review their trading activity for, and prevent, a pattern or practice of self-trades resulting from orders originating from a single algorithm or trading desk, or related algorithms or trading desks.

The rule then draws the relatedness line itself.

• Transactions resulting from orders that originate from unrelated algorithms or separate and distinct trading strategies within the same firm would generally be considered bona fide self-trades.
• Algorithms or trading strategies within the most discrete unit of an effective system of internal controls at a member firm are presumed to be related.

The interpretation closes by stating that it does not change members' existing obligations under the standards of commercial honor rule and the supervision rule.

Exam Tip: Gotchas

• A single unintentional self-trade is generally bona fide. What the rule reaches is a pattern or practice, so one crossed order between desks is not the described conduct.
• Relatedness turns on the firm's own control structure. Anything inside the most discrete unit of an effective system of internal controls is presumed related, which puts the burden on the firm's organisation chart rather than on the algorithms' code.
• The bona fide standard in the rule's main paragraph is taught elsewhere. The publication of transactions and quotations rule itself is covered in the unit on disseminating quotes and trade advertisements.

What Counts as Disruptive Quoting and Trading Activity?

The outline calls this spoofing. The rulebook describes it as disruptive quoting and trading activity, and no member shall engage in or facilitate it, including acting in concert with other persons to effect it.

The activity includes a frequent pattern in which the listed facts are present, and two patterns are described.

Type 1 has four facts.

• A party enters multiple limit orders on one side of the market at various price levels, called the Displayed Orders
• Following the entry of the Displayed Orders, the level of supply and demand for the security changes
• The party enters one or more orders on the opposite side of the market of the Displayed Orders, called the Contra-Side Orders, that are subsequently executed
• Following the execution of the Contra-Side Orders, the party cancels the Displayed Orders

Type 2 has two facts. First, a party narrows the spread for a security by placing an order inside the national best bid and national best offer, the quotation pair usually written as the national best bid and offer (NBBO).

Second, the party then executes an order on the opposite side of the market that executes against another market participant that joined the new inside market established by the first order.

A closing paragraph adds three points. The activity includes a frequent pattern in which the facts listed above are present. Unless otherwise indicated, the order of the events indicating the pattern does not modify the applicability of the interpretation.

Its third point is about venues. The activity includes a pattern conducted entirely on a single venue as well as one where some portion runs on one venue and other portions run on one or more other venues.

Exam Tip: Gotchas

• Facilitating the activity is prohibited alongside engaging in it. A member need not be the one entering the orders, and acting in concert with other persons is named explicitly.
• A single episode is not the described activity. Both types are keyed to a frequent pattern, so one cancelled order does not complete the description.
• Sequence is not an element. Unless otherwise indicated, the order of the events does not modify the interpretation's applicability.
• Splitting the activity across venues changes nothing. A single venue and a multi-venue pattern are both named.

How Is a Pump and Dump Charged?

The pump is a statement problem, and more than one provision reaches it.

The trading-side class means a dealer, broker, security-based swap dealer, major security-based swap participant, or other person selling or offering for sale, or purchasing or offering to purchase, the security.

The dump is a trading problem. It is the price-moving provision of the manipulation statute, a series of transactions effected alone or with one or more other persons, creating actual or apparent active trading in the security or raising or depressing its price, for the purpose of inducing the purchase or sale of that security by others.

The price-moving provision reaches a security registered on a national securities exchange or one not so registered, and conduct in connection with a security-based swap or swap agreement on that security. The paragraph carries no government-security clause of its own, but the subsection-wide carve-out for an exempted security, which includes a government security, applies to it as to every provision of the main subsection.

Those same elements reach a series timed to move the price at a chosen point in the session, which is the route by which a closing-price scheme is charged.

Paying for the publication is reached separately by the payments for publicity rule, covered in the lesson on payments involving publications that influence the market price of a security.

Exam Tip: Gotchas

• Two of the pump routes are written for the trading-side class only. The false-statement route and the ordinary-course circulation route both require that actor, while the paid route requires only that the payment came from it.
• The dump needs a series and a purpose. The purpose is inducing the purchase or sale of the security by others, so a single large sale that moves the price does not satisfy that provision on those facts alone.
• Paying for coverage is a separate violation from the trading. The payment analysis runs under the FINRA payments rule regardless of whether the trading provisions are also engaged.

What Should You Check on Exam Day?

• Ask whether beneficial ownership changed. No change points to the wash sale act; a matching contra order points to the matched order act.
• Treat one accidental self-trade as generally bona fide, then ask whether the facts describe a pattern or practice from a single or related desk.
• For disruptive activity, identify Type 1 by cancelled Displayed Orders and Type 2 by an order placed inside the NBBO.
• Do not require a fixed sequence of events: unless otherwise indicated, the order of the events indicating the pattern does not modify the interpretation's applicability.
• Split a pump and dump into its statement route and its trading route, and check who was paid and by whom.