Michael Karbouris, Head of Business Development, APAC, Nasdaq examines ongoing regulatory and technological changes in surveillance.
What do manipulation in the FX and LIBOR markets, the explosion of dark pool trading volumes, and the growth of high frequency trading have in common? The answer is that all of these issues are keeping compliance officers up at night, and they are having a profound impact on all stakeholders in the financial markets. In most (if not all) regions, they are influencing investors’ perception of fair and efficient markets and eroding their confidence. In response, broker-dealers, exchanges and regulators alike are stepping up their surveillance efforts across the entire trade lifecycle.
OTC market manipulation made front page news in 2012, when it was revealed that global banks colluded to falsely inflate or deflate their LIBOR rate submissions to profit from trades or affect the perception of their creditworthiness. Fast forward to 2015, and LIBOR has a new benchmark administrator, the rate-setting process has been tweaked, and the banks involved in manipulation have been fined billions of dollars.
In retrospect, poor internal controls are to blame for this market abuse – at least to some extent.
Banks lacked surveillance technology with strong capabilities to connect the dots. They could not link their positions in loans, swaps, options and futures with the LIBOR rate submissions to detect unusual pricing. Further, they were either not scanning electronic communications or not using robust enough systems to detect keywords indicating collusion. The investigation of the LIBOR scandal revealed that the scheme was devised and implemented through emails and instant messages.
Then in June 2013, yet another scandal rocked financial markets. Certain FX dealers at major banks allegedly colluded to profit by trading currencies ahead of large orders at the daily benchmark fix, and sought to influence the fix itself. Several major banks have already been forced to pay billions of dollars in penalties. Since then, the fix process has been changed so that traders need far more capital to manipulate a price because they have to keep buying or selling aggressively over a longer period. Moreover, regulators have forced banks to change their internal processes and increase scrutiny over FX trading.
In light of these incidents, the regulators expect banks to have risk management and surveillance tools that can look across markets and asset classes, and trigger alerts when unusual activity occurs. They need to be able to analyse large data sets, perform an alert run in minutes, and scan all electronic communications for suspicious keywords and relationships.
To be effective, surveillance analysts should be monitoring for patterns such as more active buying or selling, or higher volumes than usual around the fix that influence price (marking the fix), or unusual positioning ahead of the fix (front-running). They also should be watching out for instances where someone is trading a currency they do not normally trade, or trading in a size that is not normal for them.
Banks use surveillance technology not only to detect wrongdoing, but also as an investigative tool to prove scenarios, which are documented for internal and external auditors. When the regulators ask about an irregularity, the bank can say it noticed it too, and explain what was done about it. It can show an audit trail of the investigation and the related communications to explain what transpired. In doing so, it might avoid hefty fines and penalties, not to mention reputational damage.
Dark pool accountability
Electronic trading and other factors have led to a marked decrease in order sizes on exchanges. Dark pools were originally created so asset managers could execute large blocks of stock without information leakage or market impact. But regulators globally are concerned about the growth in dark pool trading and its effect on market integrity. Some countries, including the UK, Australia and Hong Kong are introducing rules to either curtail trading in the dark, or at least ensure higher levels of transparency in dark markets.
Like lit markets, it is possible for dark pools to be abused intentionally. To this end, these venues need to be on the lookout for traders who try to game other participants and manipulate open market prices by using orders that are inconsistent with their intended purpose.
One method of manipulating prices in the dark is to test liquidity by placing a small order in a dark pool to see if it gets executed, “pinging” the dark pool. If it does, a larger order is placed in the lit market to narrow the spread and push the indicative execution price in the dark market in a beneficial direction. Ultimately, a larger order is executed in the dark pool at the manipulated price.
Using a bait and switch or spoofing strategy across both lit and dark markets, traders enter orders with the goal of creating fictitious volume on one side of the order book. In these cases, traders place a large sell order in the lit market to influence other market participants to sell more aggressively. If the bait is taken, the manipulator can then buy the security at a lower price in the dark market, safely hidden away from view.
Dark pools must also monitor for front-running activity not just in the most deliberate cases of proprietary order flow being executed prior to client order flow, but also more general cases. These include front-running the release of research reports or using insider information by executing in dark markets. Typically, front-running of large price movements in a dark market may be indicative of potentially suspicious activity.
There is no one-size-fits-all surveillance solution. A dark pool that operates as a crossing network is different from one that operates as a multilateral trading facility, and the regulators treat them differently.
Ultimately, the onus is on dark pools to operate exactly the way they are advertised to operate. They need to deploy policies and procedures, human resources and automated technology to ensure integrity. A holistic surveillance system should be employed, utilising algorithms to monitor all dark market trading activity for suspicious behavior and anomalous price movements, and generate alerts when suspicious events occur. Over time, dark pool operators can understand trends and patterns, as well as the activities of specific participants active in their marketplace.
Expanding supervisory responsibilities
Many trades today are executed via algorithms. Market participants and regulators are keenly aware that fat finger errors and technology glitches can have a devastating impact on investor confidence. The flash crash of May 6, 2010 was the first in a string of such events, which has increased regulatory focus on both risk and manipulation.
The front office is required to do pre-trade risk checks as the first line of defence against machines or humans going haywire, and to ensure orders do not exceed specified limits. Traders can pre-define risky events and adjust parameters so the program will shut down in a controlled manner should any one of them occur. Additional layers prohibit traders from sending orders that exceed a certain number of contracts or shares, and orders are rejected that do not pass a price reasonability check. In contrast, market surveillance for manipulation (not risk) has mainly been a post-trade function. But newer regulatory initiatives are causing the lines between surveillance and risk to become blurred. The front office increasingly needs to watch for algorithms that can potentially be used to manipulate market prices through front-running, bait and switch techniques and spoofing. While most market participants use algorithms to execute trades, they might not be adept at examining them for potentially manipulative behavior. Surveillance systems, with logic programmed to watch for manipulative activities and patterns, can help the trading desk understand normal versus abnormal behavior and help them to mitigate regulatory risk before trading.
Overall, trade supervision is an important first line of defence to ensuring market fairness and integrity, and certainly an area that will attract more attention in the future.
The surveillance platform as the common denominator
A common solution to all these disparate issues involves taking a thoughtful, holistic approach to processes and procedures. Firms should define the role of the front office in surveillance and hold trading desks accountable for their activities. Surveillance teams should be empowered with the knowhow and tools to monitor order flow in OTC asset classes as well as dark trading activity in multilateral trading facilities and internalisation engines. In addition, firms should evaluate their current platform to ensure it is sufficiently robust to be effective and efficient across a wide array of investigations now and in the future.
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