In 2007, the SEC approved the founding of the non-profit Financial Industry Regulatory Authority (FINRA). FINRA was created in the wake of a failing economy to consolidate the regulation of securities firms operating in the United States. The authority’s responsibilities include “rule writing, firm examination, enforcement, arbitration, and mediation functions, plus all functions previously overseen solely by NASD, including market regulation under contract for NASDAQ, the American Stock Exchange, the International Securities Exchange, and the Chicago Climate Exchange.”
The mission is to safeguard the investing public against fraud and bad practices. To fulfill this mission, FINRA added two rules in 2012: Rule 2090 (KYC or Know Your Client) and Rule 2111 (Suitability).
KYC works in conjunction with suitability to protect both the client and the broker-dealer and help maintain fair dealings between the parties. The Know Your Client rule is a regulatory requirement for those responsible for opening and maintaining new accounts. This rule requires broker-dealers to access the client’s finances, verify their identity, and use reasonable effort to understand the risk tolerance and facts about their financial position.
KYC is an important rule as it governs the relationship between customer and broker-dealer and safeguards the proceedings. At the heart of this rule is the process that verifies the customer’s identity (or any other account owners) and assesses their risk level. Part of FINRA’s goal is to eliminate financial crime, which means that when a broker is accessing a potential customer, they are looking for evidence of money laundering or similar crimes. This process goes both ways as FINRA allows a customer to verify the identity of brokers in good standing with the organization.
KYC also goes hand-in-hand with the Anti-Money Laundering (AML) rule, which seeks to identify suspicious behavior, outlined under FINRA rule 3310. Crimes such as terrorist financing, market manipulation, and securities fraud are illegal acts that KYC, AML, and other rules aim to prevent.
Another part of the Know Your Client rule is the requirement of a broker-dealer to use reasonable effort to understand a client’s risk tolerance, investment knowledge, and financial position. For example, accredited investors can make Regulation CF and A+ investments without facing restrictions, while the everyday investor is limited based on their net worth and income.
When making recommendations for a client, a broker-dealer must comply with Rule 2111, the suitability rule, which means that they must have reasonable grounds for this suggestion based on a review of the client’s financial situation.
Compliance with these rules is maintained by following policies and best practices that govern risk management, customer acceptance, and transaction monitoring. Due diligence is done to know a client needs to be recorded, retained, and maintained so that broker-dealers can continuously monitor for suspicious or illegal activity. In 2020, FINRA processed 79.7 billion market events every day and imposed $57 million in fines.