By: Matt Anderson

Turnkey Trading Partners (“Turnkey”) has written extensively about the expectations of industry regulators, namely the National Futures Association (“NFA”), when it comes to oral, written and electronic communications. Since 2023 industry examinations have focused heavily on record keeping obligations in this area as well as supervisory best practices. Unfortunately regulators have not been updating or communicating well to registered firms expectations related to supervisory scope best practices. Industry regulations are often written with broad sweeping language to afford both regulators and market participants flexibility. This is entirely understandable, and in Turnkey’s view, a good thing overall for the derivatives industry. However, when regulators begin to change expectations and do not amend published literature communicating those expectations, problems tend to arise. Turnkey has reason to believe that NFA may be preparing to publish a new interpretive notice in connection with Rule 2-9 which covers supervision. Based on the approach taken by NFA during several recent examinations Turnkey participated in, this article sheds light on what may be coming in the near future.

NFA Scope Expectations?

Due to NFA suggestions, Turnkey has been asked by certain customers to assist in the development of scoping procedures. At this time these procedures are intended to supplement their already existing policies governing the supervision of company communications written, oral, or electronic. Scoping policies are intended to inform guidelines for supervisory staff as to how they might evaluate large numbers of communications. Specifically, these policy addendums are targeting the review areas related to trade reconstruction, email, chat, text, call, and other forms of communications which occur between customers and firm representatives.  CFTC Regulation 1.35 and NFA Interpretive Notice 9037 set the standard for record keeping and supervision in this area. These regulations are however largely silent on appropriate scope and review selection best practices.

Considering Scope

All brokerage and trading companies are unique. The types, frequency, and kinds of reviews which are required to be conducted as a component of the firm’s overall compliance program will differ from firm to firm. They will also likely change over time as a company’s business and staffing needs evolve. Different types of reviews which may be conducted by industry registrants could include, but are not necessarily limited to:

  • Annual AML
  • Annual ISSP
  • Annual TPSP
  • Annual BCDR
  • Branch Office Reviews
  • Accounting and financial statement review
  • General Compliance and Operational Policy Reviews
  • Various agreements and forms
  • Promotional Materials
  • Trade Reconstructions
  • Supervisory reviews of electronic communications (voice, electronic, written etc.)
  • Account opening processes

When determining a testing scope, it is important to first identify the overall purpose of the review being conducted. It is also important to be familiar with the significance of the review.  The amount of regulatory, legal, business, and reputational damage which may occur due to a failure in firm policies and procedures should be considered on a risk adjusted basis.  Not all reviews and testing areas are of the same overall materiality to operational or regulatory risk. When creating scoping policies Turnkey considers the above factors. Do the policies in place at your firm consider this? If not, now could be a good time to revisit these policies to determine their overall functionality and appropriateness. At a minimum any compliance policies, particularly those related to the supervision of communications, should be reviewed at least annually. If this is not occurring there is a high probability this area of compliance could present a major issue during your next routine NFA emanation.

Deciding Upon Approach

Once appropriate staff have clarified the subject and/or focus of a given review, they must then determine the overall approach to said review.  Questions such as the following might be useful to ask prior to evaluating any policies and procedures:

  • Is this review routine in nature? Has it occurred before? How frequently?
  • Is the review occurring due to a known deficiency or area of concern? What is the history of this concern? Am I familiar with any prior remediation efforts?
  • What is the overall significance and impact to the firm of the review?
  • Is the review being mandated by regulation? A customer request? A consultant, attorney, or regulator’s suggestion?
  • Do I as the reviewer have a firm understanding of the current policies and procedures in place surrounding the subject matter of the review?
  • Am I familiar with the approach used in previous reviews of this subject area and their results?

These inquiries can prompt careful consideration of how to structure a review. The objective of a review may vary over time and across different departments within the company. For instance, a routine Anti-Money Laundering (“AML”) review for a firm solely engaged in execution business may differ significantly from an AML review conducted by a firm that opens individual retail accounts for self-directed traders. Similarly, as the business evolves over time (e.g., transitioning from a small-scale operation with 20 customers and 3 employees to a larger entity with 3,000 customers and 50 employees) the objectives, scale, and focus of reviews will inevitably change. It is crucial to recognize that understanding the review’s objective and past review methodologies is essential for determining scope and assessing risk.



Determining Testing Thresholds

During a typical NFA audit, Regulatory examiners will distribute a “pre-exam questionnaire” to gain a deeper insight into the area(s) slated for examination. This questionnaire solicits both general and specific details regarding the subject under review. The responses provided serve to shape testing protocols and delineate the scope of the examination. Typically, before the official review date, staff members should gather preliminary information pertinent to the review. Each review undertaken by staff warrants an independent assessment, contingent upon the circumstances surrounding the testing at the time. While established review methodologies from the past may remain applicable, preparing for a review will entail being acquainted with the subject matter, assessing the information to be tested, gathering pertinent information, and asking appropriate questions to ensure no unexpected changes have occurred.

Unless there is a minimum testing scope set forth by your current policies and procedures and/or industry regulations, most audit scopes will be based on a percentage basis first. Although the percentage basis scoping method is a good start, be advised that one size does not fit all when it comes to risk based scoping!  As a rule, when initially considering scope, staff may consider a 10% materiality threshold, however this must make sense for the business and area of testing. A 10% scoping threshold may or may not produce a reasonable scope, it is simply a starting point in determining appropriate scope.  For example, it would probably not be appropriate for a business with 10 clients each doing 1 trade a month to only test 1 trade. Rather, all 10 trades should be tested because the scale of the testing is limited. However, if a company has 1,000 clients each doing 1,000 trades a month, it probably will not make sense to look at 100,000 transactions. In this case some form of automation or filtering with the review process may need to be considered. It may not be reasonable to manually consider such large amounts of data. Alternatively, if a firms customer base is self-directed traders, if the processes in place are highly automated, perhaps looking at only 100 trades per month might make sense. Although 100 trades out of 1,000,000 is a small standard, if the sample size is representative and reflective of the overall process it still may be viewed as being reasonable. Scopes can take many shapes and forms. They have to be reasonable and they have to apply commonsense to find the so called “Goldilocks – not too big, not too small” level.

If you are not testing communications or doing trade reconstructions on a monthly basis, and/or do not have a policy surrounding your scoping requirements, it is almost certain your firm will have issues during your next NFA examination.  If you would like Turnkey Trading Partners to review your existing policies, approach, or to consider your current testing parameters and accompanying scope selection, please reach out to us here.