Some buy-side firms, especially the smaller ones, have tended to take the stance that they don’t have the same level of responsibility as sell-side firms when it comes to preventing and detecting market abuse. However, this is not how the regulators see it. In the recently published MAR Level 3 Q&A (May 30, 2016) there is no room for misunderstanding amongst the buyside firms on whether their activities are fully covered by MAR. ESMA said it “considers that the obligation to detect and identify market abuse or attempted market abuse under Article 16(2) of MAR applies broadly, and ‘persons professionally arranging or executing transactions’ thus includes buy-side firms, such as investment management firms (AIFs and UCITS managers).”
Suspicious Transaction Reports (soon to include orders) from the market are usually the best source of quality cases for the regulator. Market participants who have the closest relationship with the clients and the fullest understanding of the trading strategies are almost inevitably in the best position to detect potential abusive or manipulative behavior. Training of front office staff on how to identify and escalate potential market abuse is therefore a crucial component of market abuse controls.
The High Court Judgment and £7m fine secured by the FCA in August 2015 against an asset manager and three individuals is a classic example of how buy-side firms could be susceptible to market abuse. The defendants accessed trading platforms via their brokers’ DMA services to conduct abusive ‘layering’, by placing and cancelling large CFD orders to stimulate price movement of relevant shares. The judge found that the asset manager “wholly failed to take any adequate steps to ensure that market abuse was not being committed... [and] was reckless in that regard.”
Further, the FCA’s thematic review last year on asset managers and market abuse (TR15/1) showed that only two firms in their sample “demonstrated post-trade surveillance that effectively highlighted and properly investigated potentially suspicious trades”. These results should act as a wake-up call to firms because whilst we’ve seen some of our clients taking the initiative and putting some automated surveillance in place, many smaller asset managers and hedge funds still consider themselves largely untouched by the new rules.
Buy-side firms have been wary of having to invest large sums into the sort of complex automated surveillance systems that the trading platforms and sell-side rely on. This is a quite understandable stance since such expensive and powerful systems may not be a proportionate solution given the firm’s business model.
With MAR coming into force, the key message is that by July, buy-side firms must be able to demonstrate they are recording and analyzing all of their trading activity and conducting surveillance to detect not only suspicious transactions but also suspicious orders. MiFID II implementation in January 2018 will extend the MAR’s scope to more markets and trading platforms, which means that more fixed income and derivative products will be caught by the need to have adequate surveillance.
So what does ‘acceptable’ look like for the buy-side? The answer is that firms need to demonstrate they have identified and assessed all inherent market abuse risks across all trading desks and asset classes. They need to be aware of the breadth of market abuse risks; that insider dealing can be committed using nonequity instruments, how employees could front run orders through personal account dealing (PAD), how bond prices can be ramped manipulatively and that fictitious orders could be submitted to their brokers or via DMA. Firms then need to implement an adequate level of surveillance, particularly in the second line of defense, to detect such behaviors.
Whilst there is still a role for comprehensive, well thought-out manual monitoring in smaller firms, investment in flexible automated surveillance tools could transform the quality of a firm’s surveillance. Such systems (which can detect potential instances of insider dealing, layering and spoofing, increased market participation and wash trading) coupled with PAD monitoring and, depending on how trading is conducted, risk based surveillance of emails and Bloomberg chats, are available from a wider range of vendors than ever before.
Judgment is needed in deciding what level of automated surveillance is required and which are likely to be the most cost effective solutions. However, what is clear is that doing nothing is no longer an option.