Dealing with Market Abuse Practices by Mike Lacson

Regulatory compliance is top of mind for every regulated firm across the globe. Market manipulation and insider trading activity proved to be trending topics among thought-leaders and delegates at SunGard’s City Day in Hong Kong. Philippa Allen, CEO of Compliance Asia, gave the delegates a picture of the numerous market manipulation issues faced by senior compliance managers at financial houses, and the current thinking about how to combat these issues.

Allen began by pointing out that many of these issues, originally viewed as US or European focused, is in fact very much on the mind of Hong Kong’s Securities and Futures Commission (SFC). Mark Stuart, the director of enforcement at the SFC, sites five sectors where he wants prosecutions or investigations:

• Listed companies
• Insider dealing
• Systemic risk issues
• Financial resources and reporting failures
• Market abuse

To illustrate the level of attention the SFC is paying to market abuse and insider trading issues, Mark Stuart noted he had 25 investigations as of April 2011. If you roll that out on annual basis you are looking at around 100 or more investigations per year. “Given those figures I think you can start to understand that the SFC is not slow off the mark in this area and that it is gaining in prominence. And it is not just small, old fashioned price ramping or wash trades or rigging that they are looking at, but genuinely manipulative categories of activity, looking at conspiracies, at cross-firm issues,” noted Allen.

One of the critical things firms should be able to do is stop market abuse. To do this, compliance professionals need to first know it is happening. Senior management needs to know it is going on and this requires an exceptional compliance reporting system. One of the suggestions made by the UK Financial Services Authority (FSA) is that firms should be monitoring unusually high numbers of amended or cancelled orders, which clearly came out of the SocGen case in France.

Another area that was looked at was the importance of setting limits on traders. Post financial crisis, new best practices were developed which suggest that the traders themselves should be involved in setting these limits. Additionally, traders should understand their mandates and know exactly what their limits are.

Fraud testing

Fraud testing, which is akin to computer hacking, is a manipulative behavior that is growing in popularity in the US. Fraud testing involves someone creating a fictitious transaction and then waiting see how it gets processed in your systems. Some will even get counter parties to help them with it. It is a complicated thing to do, and it’s a complicated thing to do anonymously. Allen suspects in some of the smaller markets that operate in Asia it would be a tricky thing to pull off, as people would hear about it pretty quickly. Controlling and managing this manipulative behaviour is interesting and difficult as its sole purpose is to find the weaknesses in a system.

Direct Market Access

Direct Market Access (DMA) is a current topic of interest with the Singapore Exchange. Questions being raised by regulators are:

• Does DMA create a greater opportunity for abusive trading?
  The general regulatory view is that it probably does.
• Who then is responsible, the providers of the DMA or the underlying client?
  The underlying client who executed the DMA trade, if they know it is abusive, should be held responsible. However, regulators are increasingly inclined to say that there needs to be some sort of testing by the DMA access provider.

“There will need to be a market practice that develops about who is responsible here because I think that if there is a genuine argument to say that DMA is just a hosting mechanism it would be unfair to expect the DMA provider to be held responsible for abusive trades placed by the underlying asset management clients, but that is the current position, there is a view that you should be monitoring,” Allen pointed out.

Insider Dealing

Insider dealing is clearly a ‘hot button’ issue at the SFC. Before 2008, the SFC had never secured an insider dealing prosecution, since then prosecutions have grown exponentially.

The sorts of controls that we are seeing put in place, which are applicable to both sell and buy side, are:

Transactions and valuation dates – is there any correlation?

• Comparing books against analyst visits – you may find that two days after every company visit there is an odd trade
• Comparing large positions against announcements
• Comparing winners and losers against announcements
• Comparing corporate actions and proxy votes
• Comparing sudden reversals in recommendations and trying to think of reasons why
• Comparing sudden changes in share holdings and core positions

When you do have price sensitive information, the critical question is how to use it. Certainly it is much more common practice now on the buy side to specifically want to hear ‘This is price sensitive information, do you want to receive it?’. It is crucial that investment banks have that question, to have it on your taped lines, even if the asset manager or hedge fund goes ahead and trades, it forms a core part of your defence that you actually told them that is was price sensitive and they agreed to the release of the information. It’s crucial for the sell side to have those affirmations.

Regulators across the globe are increasing enforcement actions in an effort to combar abusive and manipulative practices within financial services firms. Trending abusive behavior includes market abuse, fraud testing, and insider dealing. DMA have also created some concerns for regulators. All of these issues are vitally important for financial houses to be aware of and proactively mitigate. One only has to look at the news to see that regulators are paying a lot more attention to these issues now and it is not a choice but a requirement for financial houses.

Learn more about SunGard Protengent