Obtaining a broker-dealer license

On July 10th, 2020, our subsidiary Proof Services LLC received formal notice that its application for FINRA membership was approved. This was the culmination of a cumbersome almost-year-long process. While there are official guides from the regulators, we thought it might be helpful to others if we shared details from our experience, particularly with regard to actual incurred costs and timelines, as well as the specific vendors we chose for various pieces along the way. There are many different types of broker-dealers and the requirements and application process vary depending on the type of business you’re trying to establish. This post details our experience obtaining regulatory approval for a broker-dealer that trades US cash equities on an agency basis on behalf of institutional investors, as well as on a proprietary basis in a very limited fashion.

Official Resources:

FINRA: How to Apply as a New Broker-Dealer

SEC: Guide to Broker-Dealer Registration

Our Timeline

1. September 2019: Engaged Regulatory Ridge as our regulatory consultant
2. October 2019: Established our broker dealer subsidiary Proof Services LLC
3. November 2019: Filed Form BD, requested MPID
4. December 2019: Selected several key vendors/partners: outsourced FINOP, clearing firm, 17a-4 record retention vendors
5. January 2020: Filed Forms NMA and BR
6. April 2020: FINRA Membership Interview/Technology Demo
7. July 2020: Received FINRA notice that membership had been granted

Regulatory Consultant

Unless you’re already an expert on broker-dealer applications, it probably makes sense to engage a specialist for help as the very first step. Applying for a broker-dealer license is a complicated and nuanced process, with many disjoint and not particularly intuitive requirements. Financial regulators follow a highly structured process, and unintentional failures to work within that process can lead to setbacks and delays.

Our team has decades of experience in our space, plus we literally went through this exact same process of getting a broker-dealer license from scratch at our previous company, IEX, but we still chose to engage an outside consultant to manage our broker-dealer application process at Proof.

Both at IEX and at Proof, we engaged Shannon Fitzgerald at Regulatory Ridge. Shannon and I worked together at RBC before she left to spin out her own consulting practice. Shannon is incredibly knowledgeable, reliable, and professional, and just a wonderful person. Not only was she a well-oiled machine when it came to preparing the materials and coaching us through the various stages, but she also knows the folks at FINRA, and we did get the impression that her being involved gave our reviewers a level of comfort that made everything go more smoothly.

Shannon charged us approximately $45,000 for running our application process start-to-finish, which I believe is about average for this sort of consulting engagement. Also, the price range likely varies greatly depending on the complexity of the broker-dealer. Our application was very vanilla.

Business Plan

The first task Shannon asked us to complete was to prepare a business plan including our executive bios and describing our proposed activities. What we put together for these purposes was quite different from a more typical business plan that we might write to try to attract investors. Instead of emphasizing the compelling business opportunity and our points of differentiation, it focused mainly on the technical business lines from a regulatory perspective, the customer onboarding process, external partnerships, and the flow of customer funds and securities. Additionally, for our bios we emphasized our years of industry experience and our past supervisory responsibilities. It was not the most captivating read.

Once it was satisfactory, Shannon used this document as a blueprint to help prepare the other materials necessary for our application and to point out areas where we needed to provide her with additional background.

Corporate structure and expense sharing agreement

There are many rules and requirements for a broker-dealer, so it is helpful to have a dedicated business entity to perform just the broker-dealer functions, such that any non-broker-dealer activities are not also subject to enhanced scrutiny. We structured our company in two tiers:

1. Proof Trading, Inc. is our parent company in which we and our investors own equity. We incorporated Proof Trading in January 2019. Most of the technology we build and the content we produce (including this blog) is part of this parent company.
2. Proof Services LLC is a single-member LLC that is wholly owned by Proof Trading, Inc. Proof Services is the broker-dealer subsidiary. All trading operations will happen through Proof Services, and this is the entity that engages with FINRA. We formed Proof Services LLC in October 2019. Prior to forming the subsidiary, we made sure to reserve the name with FINRA.

We also have an expense sharing agreement in place whereby expenses, revenue, and technology is shared and allocated between the two entities. The entities have separate bank accounts and organizational documents, and each has its own board.

The Application (Forms BD, BR, and NMA)

Form BD (Broker Dealer)

The first form a firm files with FINRA (whew!) to kick off the application process is Form BD. It describes the specific classification of the business, in which states and with which SROs it is registered, and notes key external business relationships to the extent they have been determined at this point. Form BD isn’t super long (~10 pages), but it does contain several questions that I would have struggled with on my own due to a lack of familiarity with the terminology. But with Shannon’s help, it was a breeze. Shortly after filing Form BD, we requested our MPID from Nasdaq.

Form NMA (New Member Agreement)

Form NMA is the heart of the application. This is a massive undertaking with tons of requirements. In addition to answering hundreds of questions about the business, the broker-dealer must submit a great deal of supplemental materials including a multitude of policies and procedures, graphical depictions of business processes, and copies of external vendor agreements and LOIs. While it is possible, it is not ideal to make substantive changes after submitting Form NMA, so we tried to settle most key pieces including fundraising and vendor selection prior to submitting Form NMA.

Once Form NMA is submitted, FINRA has 180 days to approve or deny membership.

The vast majority of the work during the application process went into preparing Proof Services’ Form NMA.

Form BR (Branch Registration)

Form BR is a short form describing the firm’s offices (e.g. supervision, the business lines operating out of each office, etc.). Proof Services filed Form BR around the same time it filed Form NMA.

Form U4

For each associated person (employee) of the firm, you must submit a Form U4 which details their role, employment history, registrations, and disciplinary record. Each associated person also must be fingerprinted.

Net Capital Requirements

Depending on the broker-dealer’s specific business lines, FINRA has varying net capital requirements, ranging from $5,000 to many millions. This is the amount of net capital FINRA requires the firm to always have on hand to remain in good standing. There are also requirements around aggregate indebtedness relative to a firm’s net capital requirement.

Proof Services applied for a license to primarily act as an introducing broker-dealer that does not carry customer accounts (i.e. agency trading), which has a net capital requirement of $50,000. Proof Services also requested the ability to trade on a proprietary basis for testing purposes, and “any broker or dealer “that effects more than ten transactions in any one calendar year for its own investment account” is subject to a net capital requirement of $100,000, and the most stringent requirement always applies.

The broker-dealer is also expected to prepare pro forma financial statements laying out its first year of expenses, and it is expected to have enough capital in the bank to cover them.

Written Supervisory Procedures, AML, BCP, Employee Trading Policy

Broker-dealers are required to maintain a set of “written supervisory procedures (WSPs) to supervise the activities of its associated persons and the types of businesses in which it engages.” This is the playbook the CCO and other senior people at the firm follow to ensure compliance with all relevant rules and regulations. For each applicable regulation, Proof Services has a separate WSP detailing the requirement, how we intend to fulfill it, who is responsible, and how often the procedure will be performed. Basically, each firm puts together its own such playbook, and then FINRA reviews it during the application process to make sure its thorough, reasonable, and sufficient. Proof Services has over 100 pages of WSPs alone.

Additionally, each broker-dealer must assemble several policies, including:

• Anti-Money Laundering Policy: procedures for vetting and monitoring customers to prevent money laundering. Broker-dealers are also required to have an independent external party audit their AML program annually.
• Business Continuity Plan: procedures for operating the business during extenuating circumstances, for example a global pandemic.
• Continuing Education Plan: how the company ensures that employees are aware of and in compliance with the regulation. There are two aspects of such a plan: 1) The Firm Element, which entails formal training provided to employees from within the firm, typically during or in concert with the annual compliance meeting; and 2) The Regulatory Element, which entails passing FINRA exams and keeping your registrations current by completing FINRA continuing education.
• Employee Trading Policy: the trading activities employees are allowed to engage in outside of work and how the firm monitors them for violations.

Maybe if there’s interest we can publicly release all of these policies and procedures as well as our Form NMA and business plan.

Beneficiaries and Organizational Structure

We were required the provide FINRA with Proof Services’ organizational chart such that they could ensure that all supervisors had appropriate registrations.

Additionally, we had to share the breakdown of ownership for our parent company. Each of our investors was required to submit an attestation that neither they nor their beneficiaries were statutorily disqualified. I believe there also may be enhanced scrutiny for broker-dealers with substantial foreign ownership, but this situation didn’t apply to us.

Web CRD and FINRA fees

WebCRD is the online portal through which most interactions with FINRA occur. It’s where you submit Forms, manage registrations and user permissions, and fund your FINRA Flex-Funding Account (from where they pull your fees).

FINRA charges a $7500 application fee, plus additional fees for state registrations, exams, and fingerprinting. We paid about $10,000 total in fees over the course of our application.

The Membership Interview and Technology Demo

If a broker-dealer application was a movie, the climax would no doubt be the Membership Interview. Leading into it, Shannon thoroughly coached us on what to expect, and she even did a mock interview so that we felt fully prepared.

A group of 10–20 FINRA representatives sit you and your team down for a multiple hour-long session to grill you about your proposed business. Normally the interview is person, but due to Covid-19, Proof Services’ was held remotely over Zoom (cue the video chat business attire mullet).

It’s actually not as bad as it sounds. They mostly just asked us to recap the business plan, and drill down into various aspects they weren’t totally clear on from our written application. There were representatives from multiple different teams, and each of them highlighted their area of oversight to make sure we were aware of the full scope of our regulatory obligations. It was also an opportunity to meet the folks we’ll be interfacing with going forward post-approval. It certainly wasn’t a “gotcha” type of interview where they tried to poke holes in our application or trip us up. They simply wanted to clarify a couple points, ensure that we’re genuinely qualified to operate our business, and get to know us a bit.

The focal point of the interview was the technology demo. The technology platform doesn’t need to be production ready by the time of the interview, but we were expected to be in a demo-ready state before even submitting Form NMA. FINRA only provides a week or two of notice before the interview, so there isn’t time to scramble.

In our first FINRA interview at IEX, we prepared an exhaustive demonstration of just about every possible order type interaction, market data condition, and failover scenario. It was quite thorough and impressive as we had literally prepared for months. The tech demo basically took up the entire interview time slot and was definitely overkill (we were super nervous at the time, so we probably overcompensated).

For Proof Services’ technology demo, we walked through the basic functionality of our platform — order workflow, basic algo logic, monitoring tools and OMS, and the various applications within the system. It took maybe thirty minutes and wasn’t too intense. We were less nervous the second time around.

FINRA Requests

During the application process, FINRA sent Proof Services two formal letters requesting additional information, one prior to the interview, and one after. These requests each had a handful of clarifying questions about the business, and in each case Proof Services had 30 days to respond. Additionally, FINRA asked a handful of informal questions over email, which seemed to ramp up as the 180-day deadline approached. Just like during the interview, these questions seemed reasonable and in good faith.

FINRA Exams (Series 24 and 27)

One of the basic requirements for getting a broker-dealer license is having at least two General Securities Principals (Series 24) and at least one Financial and Operations Principal (Series 27) [Note: if you’re a sole proprietorship you don’t need the second GSP]. To gain these credentials, you need to pass the associated Series exams. The Series 24 also has prerequisite exams: the SIE and Series 7. Additionally, depending on your role and type of business, you may need to take other exams as well. In order to take any of these exams besides the SIE, you need to be sponsored by a broker-dealer. Between my time at RBC and IEX, I’ve taken the 7, 24, 27, 57, and 63 — it was definitely nice to have them all out of the way prior to starting Proof, but it is possible to take them during the application process.

The FINRA exams aren’t too bad but do require preparation — maybe 10–50 hours each, depending, with the 24 being the hardest. The material is not particularly interesting or relevant, or even up-to-date, but this is just one of the requirements (maybe a rite of passage?). The exams currently cost $40-$260 each to sit, and prep materials are typically in the several hundreds of dollars as well. We’ve always used STC which seems like a perfectly okay option.

As far as I know, most new firms start out with at least the two Series 24’s, but many outsource their Series 27 out of the gate, which brings us to our next topic.

Outsourced CCO/FINOP

FINRA has a specific requirement that every broker-dealer designate a CCO to ensure compliance with all regulations and a FINOP to compile various reports and accounting statements. Either or both of these jobs may be outsourced to an external consultant.

For an outsourced CCO, the market rate seems to be around $4000–5000/month. There are numerous responsibilities — some of the major ones include conducting regular checks as per your written supervisory procedures, preparing an annual report, and conducting an annual compliance meeting where you provide training and regulatory updates your team. For Proof Services, we decided to have me be the CCO in addition to my other responsibilities. While it is not an insignificant amount of extra work, we figured that 1) FINRA would see this as evidence that we consider compliance a core, critical function and 2) it genuinely is a knowledge set in which I’d like to be proficient, even if I eventually do hand the responsibilities off to someone else.

For an outsourced FINOP, the market rate seems to be about $2000–4000/month. I actually do have a Series 27, so I technically could do this role too, but it entails preparing financial statements and FOCUS reports, and I don’t have any professional accounting experience. While I regularly dealt with regulators and compliance matters in my previous jobs, I simply didn’t feel I had the relevant skills to be Proof Services’s FINOP. We evaluated two firms: ACI and Cartana Consulting, both of which seem like excellent options. We selected Cartana, and we’ve been very happy with them.

Key Vendors

17a-4 Record Retention / Designated Third Party (D3P)

One major requirement for broker-dealers is record retention. You need to keep records of all sorts of key data and documents for many years, in some cases for the life of the firm. In addition to the term requirements, this data must be stored in Write Once Read Many (WORM) format and it must be accessible by an external firm, i.e. a D3P, that can furnish it to FINRA upon request (presumably in case a firm loses its data or refuses a FINRA request).

For capturing and retaining our email, chat, and social media data, and to act as our D3P, we engaged Global Relay. We also had to upgrade our version of Slack to their Enterprise Select plan so that Global Relay could pull data via Slack’s API.

For retaining our trading records and corporate books and records. we selected Wasabi for WORM storage and SIRS as our D3P. We had initially planned to engage Patrina for both record retention and D3P services for this piece — we used them at IEX — but their quote for Proof was astronomical to the point where we didn’t even bother trying to negotiate.

Altogether we expect these services to cost us roughly $3000/year for our team of five.

Fidelity Bond

Another rule is that every broker-dealer must maintain a fidelity bond, i.e. an insurance policy, for 120% of its net capital requirement. We obtained ours through Mercer who was very easy to work with, and our policy for $120,000 in coverage cost under $1000/year.

PCAOB Auditor

Every broker-dealer is required to have its finances audited annually by a PCAOB accredited accounting firm. We evaluated several accounting firms and selected Assurance Dimensions. Naturally, we haven’t gotten to our annual audit yet, so I can’t comment yet on their service, but they did impress us enough during our evaluation to win our business. The quotes we received for a PCAOB audit were in the range of $8000–15000/year.

Clearing

Clearing is possibly the single most critical external partner for our business, so we made sure to choose our clearing firm prior to submitting our Form NMA. Here is our full blog post detailing that selection process.

Compliance Software

We did evaluate a couple of compliance software vendors: MyComplianceOffice and ComplySci. These vendors provide software platforms for things like tracking and documenting compliance requirements, issuing reminders and highlighting missed deadlines, and monitoring employee trading accounts. ComplySci’s quote was about twice as expensive as MCO, and they were both several thousand dollars per year with a hefty implementation fee on top. We decided this service wasn’t worth that much to us, and to start out we are simply tracking compliance tasks in JIRA (which we were already using for project tracking) and monitoring employee trading activity with a Personal Capital account.

Other Regulators

At Proof, we did have a small number of interactions with other regulators (the SEC and certain departments within the NY state and CA state governments), but these were just minor and straightforward requests for information.

When we were at IEX, we launched the business as a dark pool, which required us to file Form ATS with the SEC out of the gate, which was much more involved.

Build vs. Buy

It is worth mentioning that it is an option to buy an existing/shell broker-dealer and then amend its license to cover your business lines (1, 2, 3). I’m not an expert, but from reading these articles it looks like this path generally costs more upfront but can lead to a faster time to market.

We did consider this path at IEX, but we determined it probably wasn’t worth it at the time. IEX’s ATS model was on the unique side of the spectrum, so it probably would have been just as much cost and time to modify an existing broker’s license as it would be to get a fresh one.

At Proof, because we already had the IEX experience under our belt and we weren’t crunched for time, we did not seriously consider this option.

Help from our network

Another major help was just having contacts in the industry who had recently gone through or were currently going through the same process. We leaned heavily on our friends at CartaX and OneChronos to answer basic questions and provide guidance and advice throughout our application. Thank you!

Conclusion

All in all, it took nearly a year’s time, although the only intense parts were immediately before submitting Form NMA and leading up to the Membership Interview. If you add up all the costs to get us to approval, as well as our regulatory costs for the first year, it’s probably right around $100,000, although this number could have varied greatly if we had taken on more or less of the work ourselves. Hopefully this recap was helpful. Good luck on your regulatory journey, and as always please feel free to contact us with suggestions, comments, or questions.