Get Ready for Regulators to Peer Into Your Portfolio

By Jason Zweig

May 2, 2014 Wall Street Journal -  In December, the Financial Industry Regulatory Authority, which oversees how investments are sold, proposed what it calls Cards, an electronic system that would regularly collect data on balances and transactions in brokerage accounts.
If adopted, Cards would revolutionize how regulators do their jobs and could make it harder for unscrupulous brokers to bilk customers.
But some critics think it could endanger the privacy and security of investors’ confidential data. And the proposal ups the ante for Finra, which often has been criticized for letting wrongdoers slip through the cracks.

Under Cards (which stands for Comprehensive Automated Risk Data System), Finra would collect—probably weekly—a record of activity at all of the more than 4,100 brokerage firms nationwide.
Finra would scour the data continuously, looking for any hints that a firm or a broker might be taking advantage of a client: excessive trading or commissions, switching from one mutual fund to another, overcharging for bond trades, overconcentrating in risky or illiquid securities, and so on.

Cards “would provide us with a treasure trove of information and the ability to focus quicker on firms that are placing investors at high risk,” Richard Ketchum, Finra’s chairman and chief executive, said in an interview.
Social Security numbers and other personal details won’t be included in Cards, so Finra won’t be able to identify which investor an account belongs to or to match any investor’s holdings across firms. Nor will the data give anyone access to cash or securities.

Finra relies now partly on data analysis and partly on field examiners who gather information piecemeal on potential wrongdoing. With Cards, an ocean of detail would flow into Finra’s computers automatically.
That, Mr. Ketchum argues, would enable the regulator to stop at least some misdeeds before too much damage is done. And the sense that a regulatory RoboCop is watching their every move could deter some brokers from doing anything wrong in the first place.

“If we can easily compare information across firms, that will build enormously greater power into our focus,” Mr. Ketchum says. “I have no doubt that this is going to be the standard for regulation in the next three to five years.”
Some experts, however, worry that Cards could be overkill.

“This goes beyond mere concerns about Big Brother,” says Henry Hu, who oversaw data analytics as former director of the Division of Economic and Risk Analysis at the Securities and Exchange Commission and is now a law professor at the University of Texas in Austin. “I think Cards creates a new form of systemic risk.”
Mr. Hu worries that Cards would take data that is widely dispersed—say you have money scattered across accounts at E*Trade, Fidelity Investments, Morgan Stanley (MS -2.05%) and Charles Schwab (SCHW -0.52%)—and centralize it for the first time. That could make it more vulnerable.

“It’s a Pearl Harbor problem,” Mr. Hu says. “All the ships and airplanes are in one place at the same time.”
The probability of the data being breached by a disgruntled employee, a terrorist or an unfriendly government is probably very low, Mr. Hu concedes—but the consequences could be dire.

“Just read any trashy spy novel,” he says. “If you were a hostile foreign government, you would immediately put some of your top people to work” trying to crack into Cards.
Finra vehemently disputes that Cards could create systemic risk. The chance that anyone could penetrate the system and exploit the anonymous data for nefarious purposes is “infinitesimally small, out on the fringe of all possibilities,” says Steven Joachim, an executive vice president at Finra.

“The good that will come from the dramatically increased ability to reduce fraud will way overwhelm that extraordinarily remote risk,” Mr. Joachim adds.
Mr. Ketchum says he hopes that Cards will go to the Securities and Exchange Commission for final approval by next year, after further refinements and input from brokerage firms and the public.

Consumer advocates have long claimed that Finra is insufficiently tough on the brokerage industry that helps fund it. But if Cards does go through as planned, Finra’s new powers could leave the regulator itself with nowhere to hide.
“If they get all this information and fail to find a problem or to do enough about it, they could be open to serious criticism,” says Mike Stone, formerly a senior regulator at the SEC and a top legal officer at Morgan Stanley, now an adjunct professor at the Benjamin N. Cardozo School of Law at Yeshiva University in New York.

“We would welcome that scrutiny,” Mr. Ketchum says. “If we’re not using the data [from Cards] properly, that’s where we should be held accountable.”
Access to Big Data can still leave big problems festering. After all, the recent prosecutions of insider trading were set off as much by informants wearing wires as by computers running sophisticated analysis on data.

But if Finra does end up putting all its cards on the table, it will have to follow the data wherever it leads.
— Write to Jason Zweig at intelligentinvestor@wsj.com, and follow him on Twitter:@jasonzweigwsj