Never before have firms been under such close regulatory observation. The constantly evolving regulatory landscape has made it difficult for firms to adjust to new political and legislative changes that have significantly impacted the way business is done in the financial services industry. More than ever, regulators and stakeholders are expecting not just compliance from firms but for them to play an active role in the detection process. The best way firms can protect themselves against enforcement, other than through prevention techniques, is to identify abuse and report the suspicion before it comes to the regulator’s attention.
Increased regulatory scrutiny
Market scrutiny and enforcement actions have ramped up in recent years, and as a consequence, firms have seen their reporting requirements escalate. According to research by the FT, the number of suspicious transaction reports (STRs) raised to the UK’s Financial Conduct Authority (FCA) has increased by 24% in the past year. Just 328 suspicious transaction reports (STRs) were flagged to the FCA before the financial crisis in the 2007, which is in contrast to 1,626 in 2014 (up from 1,308 in 2013). This substantial uptick in STRs highlights the clampdown by both firms and the regulators on a previously light touch approach. Moreover, as found in the Global Enforcement Review 2015, penalties related to market integrity violations accounted for 84% of the total value of fines issued by the FCA in 2014.
These increased regulations are not just for show either; regulators are increasingly enforcing their decisions. Recent landmark enforcement actions include the 2014 case where UK and US regulators investigated and fined six banks £2.6bn collectively for traders’ attempted manipulation of foreign exchange and the £1.6bn fine for interest rate manipulation that Deutsche Bank received in April of 2015.
These decisions have shown the industry that regulators are not only reviewing transactions and trading activities, but are expanding the scope of their investigations to include communication with clients, stakeholders and other market participants. In addition, since the crisis, the FCA in particular has focused its attention on transaction reporting. The UK watchdog uses this trade data to detect and investigate potential market manipulation or insider trading. On 22 April, the FCA issued a fine of £13.3m to Merrill Lynch, the largest fine ever for transaction reporting failures at a firm.
Figures like these demonstrate the focus regulators are placing on market abuse – and given the increasing awareness of how abusive market activity can impact institutions and consumers alike, this trend looks set to continue. According to Kinetic Partners’ recent survey of 300 professionals across the industry worldwide, 44% of C-suite executives cited market abuse as the key area they believed regulators would prioritize in the coming year.
The first line of defense
The first step a firm takes in this active form of market abuse prevention is making sure that they have strong systems in place that can identify potentially abusive market activity, while keeping up with changes to the structure of the markets. Additionally, a firm’s first line of defense when it comes to reporting, surveillance and conduct risk is establishing clear ownership and communication at the outset of implementation – this includes apportioning responsibility between compliance, operations and IT. Accurate transaction reporting and effective market abuse monitoring both require the necessary teams to work together to have a collective understanding of not only the regulations, but also the firm’s IT systems and every facet of the business itself.
Firms already recognize that technology is critical to their ability to be compliant. 27% of financial services professionals surveyed by Kinetic Partners said that technology investment at their firm would largely concentrate on regulatory reporting in 2015, while more than one in five (22%) said market and transaction monitoring systems would be the main focus. What’s more, a one-off implementation of new technologies will not suffice. Even banks with sophisticated market monitoring systems in place need to ensure their investment in technology not only meets regulators’ expectations, but also keeps pace with developments in the industry and new requirements stemming from, for example, MiFIR and MAR.
A new era in market surveillance
The European Securities and Markets Authority (ESMA) identified that the continued and increasing use of electronic and technologically advanced trading strategies and tools, such as HFT, will continue to drive the need for continued innovation of sophisticated monitoring capabilities by both companies and regulators. From January 2017, firms will be required under MiFIR and MAR to monitor more transactions and store much more details pertaining to orders. As a result, data storage and monitoring will continue to become more complex and costly than in the past years. However, the effective implementation of these changes on a cross asset class and system basis can help limit long-term costs and mitigate the risk of regulatory action.
Alternatively, a growing number of specialist service providers now offer electronic review platforms to deal with large volumes of digital information, which have proven very useful to firms in cataloguing trade and order data without having to do it in-house
Regulators across the globe are just beginning to tackle HFT market abuse, with nascent rules on the trading strategy being introduced and tried for the first time, a practice which is expected to become more common as regulators become more familiar with electronic and algorithmic trading. The first HFT-related enforcement action by the Securities and Exchange Commission (SEC) was as recent as October 2014, but many more cases are likely to come through the pipeline in quick succession.
Advocates for less stringent regulation of HFT believe the strategy provides liquidity to markets and helps reduce volatility in most circumstances. However, while HFT may reduce volatility in some cases, it has also played a role in periodic “flash crashes”, brief periods of extremely high volatility. Although HFT is not an inherently abusive tool, it can make it harder for regulators to detect when manipulation is taking place. The recent accusation that Navinder Singh Sarao contributed to the US flash crash back in May 2010 is an indicator of the need for more granular order data to be accessible to trading venues and regulators.
Virtually every regulatory initiative around trading activity and markets in recent years requires that firms manage, review, analyze and often produce information in digital form. In this regard, certain regulators, such as the SEC in the US and ESMA in Europe, have put together detailed guidelines on how digital information should be stored and shared – making technology an extremely important sector for firms to invest in for the future.
Although costly in the short-term, the costs associated with redesigning or replacing old systems are outweighed by the long-term benefits. Advanced technological defense mechanisms are vital as the world moves to bring financial regulation into an innovative era of electronic and cross-market trading, market structure and market monitoring implementations. To ensure these mechanisms provide the maximum effect, uniformity across financial processes and jurisdictions, various stakeholders need to work in harmony to ensure compliance.
Clean and orderly markets remain a key component to a successful financial industry. The aim of maintaining orderly markets and also mitigating market abuse risk requires a significant commitment of resources, across budgets, personnel and technology. However, such an investment is critical to success for the business. It is therefore the responsibility of those firms and employees to conduct a firm-wide Market Abuse Risk Assessment and maintain market confidence by adopting the appropriate internal monitoring and control framework.
We certainly do not see the global regulatory efforts decreasing in this area anytime soon and it has become clear that firms must adapt or face the liability that comes with a poorly implemented market abuse detection system.