Merrill Lynch will pay $3 million to settle FINRA allegations that the firm's compliance procedures failed to catch instances of manipulative trading, including wash trading.

Beginning in December 2015, Merrill (and later, Bank of America Securities) failed to have a “reasonably designed” system of supervisory procedures to catch potentially manipulative trading. according to the settlement letter filed on August 28.

In particular, Merrill relied on “automated third-party surveillance” to check for such activity, including wash trading (in which brokers buy and sell shares of the same company to create the illusion of activity and market interest) and default trading (in which brokers execute trades at predetermined prices to reduce risk).

However, according to FINRA, the third-party automated parameters were too narrow to catch wrongdoing. In particular, the surveillance was limited to checking possible wash trades occurring between the same account or executed simultaneously or for the same volume and price, and then returned to the original account.

But manipulative wash trading is not limited to markets below these limits, according to FINRA. Third-party automated software had similar parameters that limited the extent of oversight of potentially manipulative default trades. FINRA found that Merril did not take “reasonable steps” to determine whether these narrowed parameters made sense for the necessary oversight.

“The firm could not explain why it initially chose the particular modules it used or why it did not choose other modules that were available from the vendor,” the settlement letter said. “Furthermore, although the firm's procedures included a review process for one of its surveillance systems, the procedures provided insufficient guidance regarding how decisions to change parameters should be made or documented.”

Additionally, FINRA alleged that Merrill failed to direct its oversight systems to trading in over-the-counter (OTC) securities during a period in 2017 and 2018 (OTC securities are those stocks that are not traded on a national exchange , often consisting of securities for smaller companies).

For several years, the firm also did not review alerts generated by some of its surveillance systems in stocks and options, according to FINRA. Merrill didn't know about the issue until August 2020, when it looked into the matter after responding to regulators in a separate investigation, despite what FINRA said were “numerous red flags, such as the results of internal testing.”

Overall, the firm did not review about 155 alerts involving about 700 potentially manipulative equity trades, as well as about 1,000 alerts involving approximately 125,000 potentially manipulative options trades, according to FINRA.

A Merrill spokesman noted there was no customer harm and said “we have improved our oversight program and will continue to implement improvements to ensure we meet regulatory requirements.”

Merrill did not accept or deny the findings in the settlement.

$669,000 of the $3 million fine will be paid to FINRA, with the remainder going to a variety of exchanges, including Nasdaq and the New York Stock Exchange. Merrill also agreed to a waiver and to report in writing within 180 days that the firm had “remedied the issues” in the settlement.