How much of a strain is trade surveillance for exchanges?

By Michael Fosbrooke | 13 July 2016

Stories of market manipulation are never far away. The Libor trials are regularly in the headlines and suspicious dealings involving FX rate rigging, the manipulation of gilt prices and price fixing cartels have all come to light over the last few years. Understandably the regulators have been laying a compliance heavy hand on the shoulders of financial organisations to try and wipe out these practices. The FCA is committed to making sure our markets are clear and to protecting and enhancing the integrity of our financial system. No mean feat then.

One of ways they are trying to improve the transparency of financial systems and boost investor confidence is through a practice called trade surveillance. The onus is on financial firms - like exchanges, brokers and banks - to implement measures that monitor the trading activities of their employees, or any third party that utilises their platform. The idea is to flag up any illicit activity, like market manipulation and insider dealing.

One of the main challenges is that the environment is so complex. Take the example of a small exchange – it might be providing a user interface to allow the trading of products, (which it provides brokerage for) and it will have a wide array of clients, such as global commercial and investment banks. It is the responsibility of the exchange to monitor the trading behaviour if its clients and partners and any other organisation that uses the platform and pass on any information relating to dodgy behaviour to the regulatory authorities.

To date, the main focus has been on post trading behaviour i.e. identifying market manipulation after it’s happened. But MiFID II means there will be as much of a focus on intent and trying to recognise market manipulation before trades have taken place. How might they do this, you would be forgiven for asking. A crystal ball? Well, there are now tools and solutions that conduct behavioural analysis and pattern recognition, vital in trying to identify violations before they occur. But the strain of policing these internal activities – and putting all the processes and systems in place to allow them to do this - is significant.

Firms are required to submit transaction reports and STRs (suspicious transaction reports), which highlight dubious activity conducted by the firm, its clients or a partner to the FCA. The regulator receives about 13 million reports a day and with this data, the FCA is able to identify any incidence of market abuse dating back to 2007. Needless to say the accuracy of these reports is vital.

To provide this accurate data, financial firms – particularly smaller organisations with limited resources - are under a great deal of pressure. And the provision of accurate, real time data is key, not only for the regulators, but for the financial company (as it’s liable for illicit trading activity), its clients and partners as they also have to prove they are being adherent.

Similarly, the implementation of the systems and processes that collect the data and ensure the exchanges are compliant has to be spot on, as does the performance of those systems. Any errors, technology failures or defects could result in massive fines from the regulator, along with the reputational fall out that non-compliance to surveillance regulation and worse, market manipulation, means. None of the banks or any of the other organisations involved in Libor manipulation, for example, have come out of it particularly well. So it’s in everyone’s best interest if the accuracy and performance of systems, processes and data is as good as it can be.

So in answer the answer is yes – the strain of internally policing activity is significant for any exchange or company involved in trading. So having the right quality assurance in place, the checks and balances that can flag up any market manipulation as agreed with the regulator, is vital and will also make sure that the implementation of the surveillance system is able to interface with existing systems, essential for accurate reporting. Having an organization-wide surveillance quality assurance strategy in place will help take the pressure off resource stretched teams, will ensure they can add value to investigations early on and importantly, avoid any hefty fines the FCA or PRA could levy for inaccurate data they provide.

By Michael Fosbrooke, Senior Consultant, Certeco.

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