BIG BROTHER IS WATCHING.
In light of the recent trading scandals, market surveillance has risen to top of the agenda. Heather McKenzie assesses the solutions on offer.
Imposing a fine of £42.4 m on UBS following the conviction for fraud of former trader, Kweku Adoboli, the UK’s Financial Services Authority (FSA) cited systems and control failings that “revealed serious weaknesses in the firm’s procedures, management systems and internal controls”. The fine, which was discounted to £29.7m for early settlement by the Swiss bank, was handed out in November last year and is just one of a growing number of increasingly hefty penalties imposed on financial firms.
In the US, financial regulators are also cranking up the pressure on firms via large fines. During the past three years, the Securities and Exchange Commission (SEC) has filed more insider trading actions – 168 – than at any other three-year period in its history. The actions were filed against nearly 400 individuals or entities and the profits or losses involved totalled around $600m.
In its statement on the UBS fine, the FSA pointed to the Swiss bank’s computerised risk management system, which it said was not effective in controlling the risk of unauthorised trading. It also said its trade capture and processing systems had “significant deficiencies” that enabled Adoboli to conceal his unauthorised trading. “The system allowed trades to be booked to an internal counterparty without sufficient details, there were no effective methods in place to detect trades at material off-market prices and there was a lack of integration between systems,” stated the FSA in its ruling.
In the wake of the global financial crisis and trading scandals, ensuring markets are fair and orderly has become a priority. Steve Leegood, an executive at market information company Bryok, says there is a perception among buyside firms that they are being “ripped off” by their sellside counterparties. “There is increasing recognition in the industry – by brokers and by exchanges – that integrity is a good thing,” he says. “Being able to demonstrate integrity is becoming a competitive weapon.”
It is an expectation that if you run a tier one market you will have high quality supervision and be able to demonstrate that to regulators, says Mark Hemsley, chief executive of BATS Chi-X. “We believe surveillance is something to keep investing in and improving.” BATS Chi-X’s surveillance team uses a combination of in-house and third-party tools to monitor trading activity. The automated system includes real-time and T+1 alerting; cross-venue monitoring across displayed and non-displayed pools of liquidity; ad-hoc reporting; scalability with high message throughput; replay capabilities; and cross-market views.
This push for integrity is not only being driven by financial regulators. Magnus Almqvist, senior product specialist at SunGard’s capital markets business, says buyside firms are taking a more active interest in how traders are executing their orders. Moreover, many buyside firms are now trading on their own account via direct market access. “Regulators are asking asset managers to monitor their own transactions for abuse and at the same time the customers of those asset managers are beginning to ask questions about surveillance.”
While financial regulators in individual countries are throwing their weight around, the European Securities and Market Authority (ESMA) has also weighed-in with guidelines on automated trading. The guidelines, which came into force in May 2012, apply to any firm that trades electronically or provides algorithms for others to access automated financial markets. “Whilst many market participants may feel they already have sufficient systems in place to address ESMA’s requirements for automated trading in equities, this is not true for all asset classes or all participants,” says Rebecca Healey, senior analyst at research firm Tabb Group. “Even for those who have solutions in place, existing systems risk becoming overwhelmed with the sheer volume and complexity of algorithms and requisite data. Necessary controls and procedures are fast proving inadequate ahead of the further legislation coming down the pipe.”
Healey is the author of the March 2012 report, Market Surveillance in Europe: Under Starter’s Orders. In it she writes: “As the trend towards automated trading is set to continue, and asset classes are forced out of the opaque shadows of the OTC world onto exchanges, the need for improved surveillance is even more critical. The result will be an ever-increasing pressure on financial services firms to collate and analyse escalating data volumes in their legacy systems, just when budgets are being tightly squeezed and any available cash for investment in technology and back-office services is evaporating.”
Despite this, investment firms realise they must appear to be beyond reproach and invest in systems that will uphold their integrity. “Internal surveillance independent of external monitoring by the regulators is essential,” Healey notes. “By firms finding internal faults ahead of the game, the opportunity exists to find solutions away from the glare of publicity and exercise successful damage control. In today’s high-scrutiny environment, market participants who implement effective surveillance programmes to uphold a vision of long-term integrity will differentiate themselves from the pack in a shrinking commission pool.”
Healey says trading firms differ in their approach to surveillance systems. Some firms are now operating at a “higher level”, supplementing the standard checks and balances with searches for events considered to be abnormal (such as a trader not taking holidays for a year). “Firms are beginning to talk about compliance as a new marketing tool – they are investing in surveillance systems not only for regulatory reasons, but also because they want to prove to their customers that they are whiter than white and can ensure that their clients are not at risk.”
Technology is not an issue when it comes to surveillance – there are myriad solutions available that can crunch the numbers required to seek out market abuse. The traditional approach to surveillance – whereby compliance officers pored over spreadsheets after an event (akin to finding a needle in a haystack) – is giving way to technology and a change in business focus. Says Healey, “Risk and compliance officers are moving from the back office on to the trading floor. Firms are addressing surveillance in real time, rather than waiting for a spreadsheet after the event.”
Being able to extend surveillance systems to monitor actions beyond stereotypical market abuse such as insider trading and front running is also becoming a popular approach says Theo Hildyard, product manager, director capital markets at Progress Software. “Firms are now looking for systems that can also monitor for fraud, rogue trading and other abnormal behaviour. They want to tighten the controls on monitoring algorithmic trading to ensure there is no manipulation, nor erroneous orders.”
A typical trading firm in the current environment has many IT demands but no money, says Hildyard. As a result they are looking for more efficient ways to approach issues such as surveillance. “Point solutions that deal with individual issues such as money laundering or insider trading are rigid and inflexible. Firms want to deal with all these issues via a single, extensible platform that requires a single interface.”
Veronica Augustsson, chief executive of Cinnober agrees that firms are looking to expand their solutions. “At a technical level, exchanges and market participants have the same needs in surveillance – a real-time feed and the ability to configure alerts. Regulators and exchanges tend to want hosted solutions while banks prefer solutions that can be accessed in the cloud,” she says. “When it comes to trade surveillance at banks, they increasingly want to include AML capabilities.”
Monitoring activity across multiple instruments and venues can be challenging for some firms, says Martin Porter, business development director at b-next. “The surveillance infrastructure at most firms supports separate instruments; the challenge is to combine that and do true market abuse surveillance across all trading activity.”
A big debate in the industry at present is how to address the ever-increasing speed of trading. “If you analyse every order that is being sent to the market, you risk slowing down that trading activity. HFT is all about getting into and out of the market as fast as possible, so when do you execute pattern trading analysis?” asks Porter.
Another discussion is centred on cross-venue surveillance. BATS Chi-X’s Hemsley says there is a potential conflict of interest in how to tackle this issue. “Solutions that are sometimes put forward require a leap of faith about who assumes the cost. There are also conflicts of interest if trading venues are asked to provide confidential customer data to a competitor; that’s not appropriate,” he says.
Such an issue could be addressed via a central surveillance utility. This would require a consolidated tape or audit trail. “Building this would be difficult, but not as difficult as it might have been a few years ago. Technology is moving on apace and there is a willingness to use technology to tackle the issue,” says Bryok’s Leegood.
Leegood likens a surveillance utility to Interpol, where policing is taken away from local forces in some circumstances. “This will move the issue away from parochialism and defensiveness in individual markets. Surveillance is a cost to be borne and there is no competitive advantage in it. Why not share the cost with others?”