Tips for Compliance Testing and Monitoring

Compliance testing ensures a company’s policies and procedures are aligned with established regulatory requirements. Effective testing goes beyond ticking boxes; it entails understanding the rationale behind each test and ensuring that business operations accurately reflect documented policies. 

These reviews are particularly significant in high-risk areas or where substantial changes have occurred. The business’s involvement in these reviews is essential to ensure policies and procedures are grounded in operational reality. 

Compliance testing isn’t a one-time task. Ongoing testing and monitoring of business operations should be a year-round activity, not only to identify compliance failures, but also to highlight when policies and procedures need to be reevaluated. This could be due to new regulations, changes in business operations, or emerging threats to the firm. 

Implementing effective compliance testing and monitoring 

The critical phase of testing a compliance program demands detailed planning and disciplined execution to confirm adherence to compliance policies and effective mitigation of regulatory risks.  

Test design should account for the firm’s unique risk profile and complement existing control measures to identify trends, patterns, or irregularities that contradict established policies, procedures, or regulations. Selecting an appropriate view period and sample size is essential to produce meaningful, actionable results. Every step of the process should be documented, including the test date, tester, area tested, results, and any resolution steps taken.

An effective testing strategy should incorporate transactional, periodic, and forensic testing modes. Each serves a distinct function, and together they provide a comprehensive view of the organization’s compliance environment. 

Testing is a continuous cycle of review and enhancement. The process begins with defining the test’s purpose, setting the frequency, pinpointing the relevant data, performing the test, and recording the results. Any discovered issues should be documented, and suitable remediation initiated. This may include engaging management, revising policy and procedure amendments, or updating disclosures.  

Discovering exceptions is not inherently negative. Instead, it signifies the effectiveness of the testing process and the firm’s ability to detect potential issues before they escalate. What matters is the firm’s ability to promptly investigate exceptions and implement corrective actions to strengthen the compliance program. 

The Chief Compliance Officer (CCO) is central to this process, ensuring management is informed of major exceptions and trends, and that all exceptions are addressed. 

A risk-based approach to compliance testing 

Compliance testing should prioritize areas that pose the greatest financial exposure and regulatory risk to the company, such as trade errors, marketing, mutual fund share class selection, and revenue-sharing disclosures. Testing priorities should also align with regulatory focus areas that have been flagged as high-risk such as marketing, custody, and cybersecurity.

An annual risk assessment is a valuable tool for strategically prioritizing policies and procedures. It helps determine whether existing controls are sufficient or need further enhancement. Using a high, medium, and low rating system to categorize the outcomes can simplify program management and focus attention on the most pressing concerns. 

A well-structured testing schedule is essential to ensure comprehensive coverage of the compliance program. The schedule should account for regulatory deadlines, including annual and quarterly filings, Form ADV updates, SEC Section 13 filings, FCA Annex IV reporting, or any other regulatory reports. Additionally, it should reflect testing and review requirements outlined in the firm’s compliance policies and procedures. 

Utilizing the trade blotter for tests and reviews

The trade blotter serves as a versatile tool for conducting a variety of tests, including identifying the use of unapproved brokers, detecting trades in securities on the firm’s restricted list, and verifying appropriate share class selection when trading mutual funds for clients.  

Blotter testing can also reveal potential market manipulation, such as window dressing and portfolio pumping, by scrutinizing trading activity, especially toward the end of reporting periods. While these tests may generate false positives; each alert requires careful examination to validate its accuracy. 

The trade blotter can also be tested for cross-trading activity and share class selection. For firms engaged in cross trades, blotter testing helps ensure these transactions are identified and that proper procedures were followed. For mutual fund trading, share class reviews have become a crucial part of best execution testing. 

Blotter reviews can also reveal deviations from standard workflows that increase the risk of manual errors and oversight failures.  

Consider using a technology solution that can streamline trade blotter reviews, minimizing the amount of time and resources needed for thorough analysis. 

Annual compliance reviews 

A firm’s compliance program should undergo a holistic review at least once a year. This comprehensive assessment ensures the program’s continued effectiveness and identifies areas for enhancement.  

The review should cover all aspects of the compliance program, including compliance testing and monitoring activities, risk assessments, role assignments, and resource allocation. It should also summarize any significant business changes or regulatory updates.  

Evaluating the adequacy and effectiveness of policies, procedures, and controls is key. The annual review should spotlight the most significant exceptions uncovered during testing to assess whether they indicate a need for program enhancements—whether through revised policies, updated testing and monitoring practices, improved reporting, or enhanced training.  

Want to learn how to build a robust compliance program? 

Download our guide for key considerations on how to design and maintain a program that not only meets regulator expectations but also equips your team to adapt as compliance demands evolve.