Interactive Brokers Settles with FINRA Over Free-Riding Violations

Interactive Brokers, LLC, a prominent name in the online trading world, has reached a settlement with the Financial Industry Regulatory Authority (FINRA) after failing to catch a significant number of free-riding violations in its cash accounts. The firm has agreed to pay a $2.25 million fine to resolve the issue, which stretches back from October 2015 through December 2022.

The term “free-riding” may sound technical, but it refers to a pretty straightforward rule violation: buying and selling securities without paying for them in full. For a company like Interactive, which serves both retail and institutional clients, it’s vital to stay on top of such activities to ensure everything runs smoothly and in compliance with regulatory standards. Unfortunately, the firm didn’t meet that standard during this period, missing over 4.2 million instances of free-riding by customers in their cash accounts.

The Crux of the Issue: A Missed Detection System

At the heart of the matter was a flaw in Interactive’s automated surveillance system. Designed to catch instances of free-riding, the system was supposed to flag such violations in cash accounts — a key safeguard against improper trading. However, the system wasn’t programmed to spot free-riding involving options and issued options, a glaring omission. As a result, more than 20,000 customers were able to engage in free-riding without being flagged by the system, violating key regulations including Regulation T and FINRA Rule 4210.

In essence, when these customers bought securities without paying for them upfront, they were supposed to face a penalty — a 90-day freeze on their ability to delay payment beyond the trade date. Unfortunately, the surveillance system missed it, and Interactive failed to impose this freeze or demand full payment for subsequent trades.

What Went Wrong: Oversights in the Supervision Process

It wasn’t just the technology that let the firm down. Interactive also failed to put in place a sufficient supervisory system to detect and stop these violations. FINRA Rule 3110 requires firms to maintain a robust supervisory system, one designed to spot issues like free-riding and take swift action to correct them. However, Interactive’s written supervisory procedures (WSPs) were missing key steps to monitor free-riding in options. Moreover, the surveillance system itself hadn’t been properly tested or audited during the relevant period, allowing the oversight to go unnoticed for years.

To add to that, while the firm did implement a fix in 2023 — updating both its surveillance system and its procedures — the damage was already done. The firm is now facing the consequences of this misstep in the form of the $2.25 million fine and a public censure from FINRA.

Resolution & Next Steps

Interactive Brokers has agreed to settle the case by paying the fine and updating its procedures. In fact, the firm took steps to correct its surveillance flaws as early as 2023, adjusting its system to monitor for free-riding in options. The firm also revised its supervisory procedures to better align with FINRA’s requirements, ensuring that future violations like this one won’t slip through the cracks.

It’s important to note that while Interactive has consented to these findings, the firm hasn’t admitted to wrongdoing. However, they have agreed to the sanctions and are working toward implementing the necessary changes to prevent future compliance issues.

While this particular case centers around one firm, it serves as a reminder to the industry about the importance of constant vigilance when it comes to compliance. With ever-evolving technology and regulatory requirements, firms must stay on top of their systems, audit regularly, and be proactive in correcting any issues before they spiral into costly violations.

For now, Interactive Brokers will pay the fine and move forward with improved systems in place, but the settlement sends a message about the need for all firms to stay ahead of the curve in maintaining a strong, compliant trading environment.

The GRC Report is your premier destination for the latest in governance, risk, and compliance news. As your reliable source for comprehensive coverage, we ensure you stay informed and ready to navigate the dynamic landscape of GRC. Beyond being a news source, the GRC Report represents a thriving community of professionals who, like you, are dedicated to GRC excellence. Explore our insightful articles and breaking news, and actively participate in the conversation to enhance your GRC journey.