Equities trading focus: Trade surveillance : Stefan Hendrickx

Market vs trade surveillance

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Firms are increasingly viewing surveillance and compliance as a horizontal capability across the firm. Why is this and what tools are on offer? Ancoa’s Stefan Hendrickx reports.

Blurred lines? How horizontal trade surveillance can help

In light of the Libor and Forex scandals over the past few years, traditional approaches to trade surveillance and monitoring are being questioned.

And with good reason. Eight major banks were collectively fined more than $6bn after regulators found large scale rigging of key benchmark rates, and it won’t stop there. In the coming years, private class act lawsuits will keep biting the banks’ bottom lines. More recently in 2014, six global financial firms were fined $4.3bn for their role in rigging foreign-exchange rates.

Financial institutions can no longer afford to take a myopic, tick-the-box approach when it comes to regulatory compliance. To be truly effective, surveillance and monitoring need to take a horizontal approach incorporating the organisation as a whole. But is current trade surveillance technology capable of handling this new horizontal requirement?

Silent silos

The 2008 Libor scandal saw traders’ conversations through instant messaging hit the newspapers, with a focus on cross-firm gaming of submissions in order to set respective bank interest rates to make profitable trades by moving the Libor rate in a favourable direction. The technological culprit? A siloed approach to trade surveillance. Simply put, the Libor manipulation went unnoticed for years because existing surveillance capabilities and approaches created inevitable blind spots between disparate systems.

The capability to monitor electronic communications has been standard practice at banks for many years, so how could this happen? Unless integrated into a single overall surveillance system, many instances of suspect activity slip through the net as snippets of conversation mean little without understanding the wider context. This is true for rate submission, but leaves many gaps open to potential abuse in other areas of the bank.

Chinese walls?

Horizontal surveillance is not only a requisite in aligning the technology that makes up monitoring systems; it can also be applicable to the physical departments that make up an organisation.

Chinese walls, developed to prevent leaks of corporate inside information within certain areas of financial institutions, are notoriously hard to monitor. It is not sufficient to look at how the mergers and acquisitions (M&A) or research arm of a firm is communicating with the trading division. Communications coming from the M&A department need to be overlaid against actual trades in order to filter out potentially abusive events. This type of contextual surveillance system can also be effective in identifying if traders are front-running news from an analyst’s recommendations of that same firm. Traditional surveillance systems that listen simply to a few randomly selected communications or use a stand-alone lexicon analysis application are considered blunt tools in terms of alerting companies to potential cross-firm abuse. It is the capability of combining multiple sets of relevant information, incorporating submissions and trades along with electronic communication monitoring into one system, that provides the most useful and insightful analytics.

Cultural shift

Responsibility of upholding free and fair financial markets no longer falls solely on the shoulders of the lone compliance officer. At the highest levels, IOSCO has drawn up a broad set of Guidelines on Principles for Financial Benchmarks (IOSCO Principles), which focuses on a holistic approach to the appropriate governance arrangements in place in order to protect the integrity of the Benchmark determination process.

The IOSCO Principles require organisations to evidence the fact that the right person is doing the right job at the right time. The right person being someone who has all the correct, up-to-date attestations (i.e. qualifications and training) in order to undertake their duties. Tight system controls are needed to ensure that the person is doing the right job, by tightly restricting functionality to their role requirements. System controls are also needed to ensure that activities take place at the right time (for example, that benchmark submissions are made when required by the benchmark administrators).

Likewise, Clive Adamson, Director of Supervision of the FCA spoke last year about KPMG’s Three Lines of Defence Model – which is now an obligation for banks to follow:

“While I support a strong three lines of defence model, it seems to me that the conduct question is more a business model and cultural challenge and therefore should be firmly rooted in the first line. The fundamental reason for this is that fair treatment of customers and proper behaviour in markets are inextricably linked with how businesses are run or, in terminology I have used before, it is about doing the right thing for the customer.”

With the Head of Desk as the first line of defence, compliance as the second line and internal audit as the third line, it is no longer one department’s responsibility.

In practice this means that trade surveillance has also increasingly become a front-office responsibility. The regulatory requirement for separation of the front- and back-office functions nevertheless still allows for the implementation of horizontal surveillance systems to enable knowledge sharing of underlying data or workflows. Data and capability resource pooling within a surveillance system can still be applied on a horizontal level, albeit the system is independently operated and information flow tightly governed in order to meet compliance rules.

Data

The need to maintain a full history of data which can be interrogated holistically cannot be underestimated. With ever-increasing scrutiny from auditors and regulators alike, organisations need to have the necessary information available to answer questions.

Vertical risk

The risk of organisations facing astronomical fines is giving cause for a rethink in the field of trade surveillance. Tools that can truly see across whole organisations – beyond the siloes of the traditional market surveillance tools and beyond the Chinese Walls set up to protect the interests of the client – are needed. The regulators have set the bar at a higher level, protecting the fair treatment of customers and the proper integrity of the market. Horizontal is the new trade surveillance. Overlay of electronic communications and contextual surveillance across departments, including the front- and back-office, should be critical components of a firm’s trade surveillance platform. In order to stay alert, organisations can’t afford to be anything but horizontal.

©BestExecution 2015

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