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Difficulty: HardProhibited Market Manipulation and Fraudulent Practices

Match each described market manipulation or compliance violation scenario with its corresponding prohibited practice under FINRA and SEC rules.

  • A broker-dealer routes a retail customer's equity order through an unaffiliated middleman broker, resulting in an additional commission markup without providing any price improvement or execution benefit.Interpositioning
  • Two colluding market participants execute prearranged transactions for a thinly traded stock between their respective accounts at incrementally higher prices to generate artificial volume and attract buyer interest.Painting the Tape
  • An institutional trading desk enters a series of buy limit orders at the current bid price right before options expiration specifically to prevent the underlying stock price from falling below an option strike price.Pegging
  • An investor purchases securities in a cash account and sells those same shares prior to the settlement date, using the proceeds generated from the sale to satisfy the original purchase obligation.Freeriding

Answer

Routing orders through an unnecessary middleman matches Interpositioning; collusive trading to fake volume matches Painting the Tape; entering orders to hold prices above a floor matches Pegging; selling unpaid cash account purchases matches Freeriding.
Each scenario illustrates a distinct regulatory infraction: inserting an unnecessary third-party broker for additional markups is Interpositioning; executing collusive prearranged trades to fake volume is Painting the Tape; entering orders to artificially support a price level is Pegging; selling unpaid securities in a cash account to cover the buy trade is Freeriding.

Step-by-Step Solution

1
Evaluate Scenario 1: Unnecessary middleman broker inserted into customer order routing.
Matches Interpositioning.
FINRA Rule 5310 (Best Execution) prohibits interpositioning, which occurs when a firm inserts an unnecessary third party between the customer and the best market, imposing extra costs.
2
Evaluate Scenario 2: Collusive traders executing prearranged trades to simulate market activity.
Matches Painting the Tape.
Creating deceptive ticker tape activity through prearranged or matched orders gives a false impression of genuine market demand, violating Section 9(a) and Section 10(b) of the Securities Exchange Act of 1934.
3
Evaluate Scenario 3: Bidding on a security to establish an artificial price floor around option expiration.
Matches Pegging.
Pegging (or capping) involves placing buy or sell orders intended to manipulate or stabilize a security's price at or near a predetermined level rather than allowing free market pricing.
4
Evaluate Scenario 4: Selling a cash account stock purchase before settling and paying for the initial trade.
Matches Freeriding.
Under Federal Reserve Board Regulation T, full cash payment for purchases must be made before securities can be sold. Selling prior to payment and paying with sale proceeds is illegal freeriding, resulting in a 90-day account freeze.

Key Concept

Prohibited Market Manipulation and Fraudulent Practices under SEC and FINRA Rules
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Prohibited Market Manipulation and Fraudulent Practices