Decoding Compliance Risk Concepts: Strategies for Effective Risk Management

Types of Compliance Risk

Over the last several years, examinations have evolved to become more risk-based and data driven. Both FINRA and the SEC have indicated they use risk-based assessments to determine the scope and areas they will examine. To prepare for risk-based exams and regulatory focus, firms need strategies for developing and maintaining a risk-focused compliance program. 

Regulatory Risks

It is important that you understand the current, updated and new regulatory requirements that impact your firm.  These requirements may be from the U.S. Securities and Exchange Commission (SEC), the states in which your firm operates, the Financial Regulatory Authority (FINRA) or stock and options exchanges. From amendments to AML and cybersecurity requirements to off-channel communications, your regulatory compliance program must be able to adapt quickly with updated policies and procedures tailored to your firm. Your policies, and the processes that support those policies, should reflect how your firm operates, your firm’s product mix, and your firm’s tolerance for risk – just to name a few considerations.  

FINRA Rule 3110, one of FINRA’s most important rules, requires a member firm to establish and maintain a system to supervise the specific activities of its associated persons to achieve compliance with the applicable regulations and FINRA rules. This includes transaction and reporting processes.

Operational Risks

Compliance plays a critical role in managing operational risk by establishing frameworks that identify, assess, and mitigate risks stemming from internal processes, systems, or human errors. Monitoring internal controls, especially those related to client data security, transaction processes for trading securities, and vendor management is a vital component to mitigating operational risk.

Market Risks

Economic volatility and market risks can significantly impact compliance. Fluctuating markets often lead to higher trading volumes, changing client behaviors, and evolving product offerings. Ensuring compliance with suitability standards, disclosure requirements, and trading rules requires monitoring. Additionally, economic instability can expose gaps and stress a firm’s ability to meet capital and liquidity requirements.  Considering these factors, a proactive compliance approach seems essential to navigate these challenges effectively.

Market Access remains on FINRA’s examination priorities, and compliance teams should proactively address it. Rule 15c3-5 (the Market Access Rule) requires firms with market access or that provide market access to their customers to “appropriately control the risks associated with market access so as not to jeopardize their own financial condition, that of other market participants, the integrity of trading on the securities markets and the stability of the financial system.”  

Failure to address market risks not only attracts financial penalties from regulators; your firm’s reputation with its clients could suffer from this exposure. 

Establish a Risk-Based Compliance Framework

Conduct a Risk Assessment

Understanding the risks affecting your organization is the key to prioritizing your controls. A comprehensive risk assessment will help determine how and when to implement controls. The current regulatory environment places significant emphasis on customizing certain aspects of your compliance program based on the risks associated with your business model. A formal risk assessment and defining additional controls allows for compliance and supervision efforts to be more targeted to higher-risk issues.

Identify High-Risk Areas

FINRA and the SEC each produce annual reports identifying areas of risk and topics of regulatory focus for the coming year. Firms should include these “exam priorities” in any regulatory risk identification process.  Does your firm have a control to mitigate that risk?  Do you have a system in place to monitor that risk?  How strong is your firm’s mitigation and monitoring?

In addition to the current stated exam priorities, other high-risk areas may include third-party vendors, new rules or requirements, and previous findings that have not yet been corrected.

Set Your Firm’s Risk Tolerances

Once your firm’s risks are identified, you must classify each risk based on the likelihood it will occur, the severity of the risk, and the tools available to manage it. Define acceptable levels of risk and create tailored controls to manage them effectively or consider eliminating the risk by not engaging in the activity.

Leverage Technology and Data Analytics

The Role of Technology in Managing Compliance

Technology solutions to meet your regulatory obligations and internal requirements can enhance your program and make it more efficient.  That said, any technology chosen must be tailored to your firm’s needs. A very simple solution may not get you the efficiency you need, but a system that is too complex may create inefficiencies. Take care when evaluating any systems to ensure the product meets your needs and, importantly, fit into your supervisory regime.

As the use of artificial intelligence (AI) becomes more prevalent, regulatory concerns and risk management challenges will come into focus as firms increasingly adopt AI technology.  

Data Analytics for Risk Detection

Predictive analytics can identify patterns and potential red flags using data.  Information from multiple sources, such as internal operations, customer behavior, and market conditions can identify patterns and anomalies, indicating potential risks. When unusual patterns occur, predictive analytics can prompt the firm to investigate and act as needed.

Automating Routine Compliance Tasks

Modern Governance, Risk and Compliance (GRC) software can enhance risk monitoring and reporting capabilities. A strong, automated compliance platform provides the supervision and reporting structure regulators demand, enforces controls, documents work, and streamlines tasks. For example, digital solutions can streamline client onboarding. By utilizing a platform with options such as electronic signature or automated compliance checks, firms can significantly reduce the time it takes to onboard new clients while enhancing security and compliance.

Foster a Strong Compliance Culture

Leadership and Tone from the Top

A successful compliance program relies on a firm-wide commitment to ethical behavior and adherence to regulatory requirements. The CCO plays a crucial role in fostering this culture of compliance by communicating the value of compliance across all levels.  CCOs should work closely with other senior management to secure buy-in for compliance initiatives and resource allocation. 

Training Programs

Regular, scenario-based compliance training can help employees understand and better manage risks. Training should cover a range of topics, including the firm’s compliance policies, regulatory requirements, and the importance of ethical conduct in wealth management. The CCO must ensure that training is tailored to the specific roles and responsibilities of employees, providing them with the knowledge and skills they need to comply with regulations.

Encouraging Incident Reporting

Encourage a culture where employees feel comfortable reporting potential risks without fear of retaliation. Implementing a robust whistleblower program is a proactive measure for companies to address issues internally, fostering early intervention and reinforcing compliance efforts. Employ a system of clear procedures and trained personnel to manage and investigate complaints.  Without a strong system of reporting in place, organizations risk mishandling serious allegations, which could escalate into external investigations or reputational damage.

Enhance Reporting and Documentation Practices

• Comprehensive Reporting. Comprehensive compliance reports are essential for maintaining an effective compliance program.  Transparency, current risk assessments, mitigation strategies, and emerging threats are all key pieces of comprehensive reporting.  These reports enable firms to proactively identify vulnerabilities, track the effectiveness of mitigation efforts, and adapt to new regulatory changes. By delivering these insights to leadership, compliance reports ensure accountability and support informed decision-making, helping to align the organization’s practices with its risk tolerance and regulatory obligations.
• Documentation as Evidence. Not only is it required, but documentation serves as evidence of a firm’s proactive efforts to achieve compliance.  Detailed records demonstrate the firm’s commitment to regulatory compliance, support accountability, and help streamline response to audits or investigations. Proper documentation also creates a reliable trail to verify decisions, actions, and training efforts, ensuring transparency and protecting the firm in cases of regulatory scrutiny or legal challenges.

Collaborate with Key Stakeholders

Collaboration between compliance and areas like the trade desk, operations, IT, and legal helps ensure that risks are identified, assessed, and mitigated from multiple perspectives. By working together, these teams can align policies with operational realities, integrate technological safeguards, and address legal implications effectively.

Third-Party Compliance Risk Management

Regulatory requirements are increasing for managing risks associated with third-party vendors, such as custodians and technology providers. A robust risk management program addresses vendor accountability, and incorporates recognized cybersecurity frameworks such as NIST  into vendor contracts.  Considering the critical role of data security, access controls and ownership of your data is a necessity of negotiating a strong Service Level Agreements (SLAs) with third party vendors. Firms should also conduct routine testing and verification of vendor activities and transactions. 

Adapting Compliance Strategies to Evolving Risks

A proactive, risk-based compliance strategy tailored to the unique challenges your firm faces is vital to mitigate your risks. Your compliance program should evolve as the industry and your firm’s business model, products and services change. This means firms should engage in routine audits and assessments to identify gaps, test controls and adjust the compliance program as necessary.

Your Partner for Managing Compliance Risks

The keys to a successful compliance program are proactive planning, thorough documentation, continuous education, and embracing technological advancements to safeguard client interests and enhance operational resilience. Continuous vigilance, adaptation to regulatory changes, and a commitment to best practices will ensure that your firm not only complies with the law, but also thrives in an increasingly complex financial landscape.

Oyster’s experts have the CCO, FINRA, SEC and state regulatory experience to help solve complex regulatory challenges. Oyster Consulting provides compliance support to broker-dealers and registered investment advisors (RIAs), including risk assessments, testing, remediation, outsourced compliance roles and automated compliance solutions.