Broker-dealers are taking a liking to cloud computing. Everything from order entry to execution and settlement to storing colossal amounts of trading data has found a place in the clouds of computing capacity tied together by global networks.
You would think that the topic of cloud computing would be addressed directly by now by the Securities and Exchange Commission or the Financial Industry Regulatory Authority or both. As of the date of this article, however, neither regulator’s website has any reference to the cloud.
Are the regulators simply unaware of the puffy billows floating by? Not a chance.
They treat cloud computing as a specialized form of outsourcing, and cloud computing arrangements must, among other requirements, satisfy regulatory guidance governing outsourcing.
In July 2011, the SEC approved FINRA’s proposal to establish a new registration category and examination requirement for operations personnel who play an integral role in the business of a broker-dealer.
FINRA Rule 1230(b)(6), which took effect on October 17, requires that any person who supervises, or has authority to commit a firm’s capital in furtherance of, a broad range of activities of a broker-dealer’s business (such activities referred to as “covered functions”) be an “associated person” of the firm and registered as an Operations Professional.
FINRA is particularly concerned about those “covered functions” that involve customer funds, accounts and transactions. Being an “associated person” is a big deal, because the firm must directly supervise and maintain registration of such individuals, subject to examinations and regular filings with FINRA.
This rule is very significant for firms and their cloud service providers. FINRA makes it clear that “associated person” status is not determined based on the location from which functions are performed on behalf of the firm. Persons at a third party provider, including those located abroad, may be drawn within the rule, if they supervise, or have authority to commit a firm’s capital in furtherance of, “covered functions.”
FINRA provides some guidance as to the scope of the new rule. Persons not required to register as an Operations Professional are those whose activities are limited to performing a function ancillary to a “covered function.”
Also, those whose function is to serve a role that can be viewed as supportive of or advisory to the performance of a “covered function,” as well as those who engage solely in clerical or ministerial activities in a “covered function,” are not subject to the new registration requirement.
For smaller broker-dealers, a majority of the “covered functions” are typically performed by a clearing firm. Many clearing firms offer a range of cloud-based services to their correspondent broker-dealers, pursuant to a FINRA-approved clearing arrangement. Under these clearing arrangements, “associated persons” of the clearing firm, rather than the firm itself, supervise the “covered functions,” and would be required to register as Operations Professionals.
The situation becomes trickier when the clearing firm, in turn, looks to outsource its activities to a third-party service provider.
In March, FINRA submitted for industry comment proposed Rule 3190, which includes heightened restrictions and obligations on clearing firms. The proposed rule, subject to a limited exception for clerical or ministerial activities, requires an “associated person” of the clearing firm to perform any movement of customer proprietary cash or securities, preparation of net capital reserve formula computations, or the adoption or execution of compliance or risk management systems.
The clearing firm must adopt additional procedures to oversee third-party service providers to make certain the firm takes prompt corrective action if needed to ensure compliance with applicable requirements, as well as approve any sub-contracting by the service provider.
Proposed Rule 3190 requires clearing firms, within thirty (30) days of entering into an outsourcing arrangement, to provide FINRA with a description of the outsourced function, the identity and location of the service provider, whether it has any affiliation with the clearing firm, and the identity of the service provider’s regulator, if any.
Clearing firms would need to notify FINRA of all existing outsourcing arrangements within three (3) months of the effective date of the new rule. Though not required by the proposed rule, a clearing firm may seek a review by FINRA for approval prior to entering into an arrangement with a third-party provider. In the coming weeks, FINRA is expected to submit for approval by the SEC the final version of its proposed Rule 3190.
On October 25, 2011, FINRA issued proposed Rule 4516, which more clearly recognizes a cloud computing model for storage of a clearing firm’s records. The proposed rule would require a clearing firm to physically store certain records at its principal office, but provides an exception for records stored electronically if tagged and indexed and “accessible from the [clearing firm’s] principal office.” The comment period for the proposed rule is open until December 9.
To comply with FINRA’s outsourcing rules, many broker-dealers and their cloud providers may find it tempting to characterize services in the cloud as merely “ancillary,” “clerical and ministerial.”
Such a characterization will be increasingly difficult to sustain as cloud providers look to differentiate and “climb the value chain.” Both broker-dealers and their cloud providers should stay closely tuned to developing regulatory rules and guidance.
This column originally appeared on Securities Technology Monitor.
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