With increased competition, fragmentation and diversity in asset classes, the job of exchanges and regulators around the world in surveying their markets is becoming increasingly difficult. Serious investment is required to stay ahead of the fraudsters. Alan Duerden explains.
Usually orderly beasts, stock markets are managed, regulated and generally kept shipshape through a varied mixture of stock exchange and national regulator oversight. On a normal trading day, the surveillance systems used to help these bodies control the market can easily churn out a mixture of both real-time and historical market data, which can be analysed, digested and, if necessary, acted upon.
Recent unsteadiness in the US subprime mortgage market has spilled over into other asset classes, drying up liquidity and forcing central banks in Europe, the US and Asia to step in and bail out some of the floundering market participants. This liquidity crisis, caused when assets cannot be quickly sold for cash, has resulted in heavy fluctuations on stock markets around the world.
Such fluctuations have naturally tested the resilience of market surveillance systems and highlighted the speed at which abnormal market movements can snowball. In markets that can change so quickly, the role and size of market surveillance systems used by exchanges and regulators has had to evolve and at an even quicker pace.
Originally, most of the exchange surveillance systems had been built in-house but as the needs of the exchanges has changed and trading volumes have increased, exchanges are relying more on using outside vendors, such as SMARTS Group, an Australian based provider of real-time market surveillance systems, to develop data reporting tools and analytics tools and run these in conjunction with internal databases that have been built up over the past decade.
“Larger exchanges had a more do-it-yourself approach in their first generation systems, built in the 1990s when exchanges began automating their operations. These home-grown systems are now reaching end-of-life,” says Thomas Jones, CEO at SMARTS Group.
The older exchange systems were only built to handle tens of thousands of transactions a day, whereas today’s markets are generating millions of transactions. Coupled with that, volumes have been driven by an increased diversity of asset classes – older systems were built to handle equities, a relatively straightforward instrument to monitor compared with derivative instruments that require relatively sophisticated pricing models. “Unless an exchange can understand at a high level if the derivatives that it has trading on its platform are being traded at a ‘fair price’, then the exchange is in no position to ensure a fair and orderly market,” says Mr Jones.
“In real time, brokers and funds will execute complex strategies over multiple venues and, for systemic market integrity, surveillance systems will need to have a view over all these venues and a reasonable understanding of the activity.”
Surveillance versus supervision
As markets have become more electronic, it has become increasingly possible for market surveillance tools to pick up abnormal trading patterns and identify things that may be worthy of investigation at a more formal level. Here it is useful to separate the concepts of ‘surveillance’ (detecting market fraud, an activity usually undertaken by the regulator) and ‘supervision’ (maintaining an orderly market, an activity usually undertaken by the exchange and involving the monitoring of auctions, market maker responsibilities, unexplained dramatic price rises, and unusual trade prices).
These two functions serve two very different but necessary purposes. Real-time surveillance is not typically directed at detecting market abuse, but rather at identifying something unusual and reacting to it in real time by cancelling an order or trade, asking a company to issue a press release, or halting trading in a particular stock.
As trading has become quicker, risk management visibility has had to become closer to real time – if you can supervise the market in real time, you can prevent the market being affected by abnormal action.
This was seen in 2005, when a failure of market supervision on the Tokyo Stock Exchange (TSE) allowed a broker at Mizuho bank to initiate a ‘fat-finger order’. Rather than selling the one share in J-Com Co, a job recruiting firm, at ¥610,000 ($5300), the broker sold 610,000 shares in the company at ¥1, losing the bank $225m. Although the TSE did have systems in place to give it real-time information, it lacked the processes around those systems to initiate any action in real time and did not have a clear way to suspend trading or directly cancel the order. If the trade had been prevented, the broker would have been saved a loss of millions of dollars.
“IT systems are not enough,” explains Anders Ackebo, senior vice-president of surveillance at OMX, the Nordic exchange. “You must also follow the flow of information from the listed companies all the time and take part in the financial information that is available at different kinds of new media. It is also necessary that the staff in the surveillance function are experienced enough to take proper action when irregularities are detected.”
While the right kind of trading culture and correct processes need to be in place for an efficient market supervision, where real-time systems come up short is that they are in real time and do not allow the luxury of a time buffer in which a particular event can be looked at in depth.
A source from a large European exchange, who did not want to be named, told The Banker: “With real-time surveillance you don’t have client level information and this is a key limitation. You are not able to see on a real-time trade report whether there is a pattern of behaviour with a particular client. Obviously, we can see what firms are doing but what we don’t have is client reference information and we don’t have the ability to see in real time the clients behind the trades.”
Clearer picture
By contrast, market surveillance undertaken by the regulator is usually done at the end of the day, or in some cases at the end of the week. Information is gathered at the exchange level and sent to the regulating body where analysis is conducted, allowing for a better overall perspective of the event that has occurred. Given the luxury of time, the regulator can utilise a greater variety of information – looking at yesterday’s, last week’s and last month’s reports – and try all kinds of analysis to build a clearer picture of what has happened.
The importance of having skilled people behind the market surveillance process cannot be underestimated. Regulators recognise this and fill their ranks with people who are steeped in prosecution and legal experience. The Norwegian market, historically renowned as being somewhat ‘wild’, is one example of where the employment of legal and prosecution professionals helped to encourage a more tightly regulated market. One man in particular, Sverre Lilleng, who is now head of market surveillance at Oslo Bors, was introduced from the crown prosecution service in Norway and was brought into the exchange to help it with its surveillance and particularly with insider trading.
In recent years the market has been very successful and trading volumes have increased massively – partly because the market is much better regulated, with a crown prosecutor in place to gather information, aid the police and prosecute in court where necessary.
For effective real-time market surveillance a mixture of both real-time and historical data is needed. “The two go together and you want to be able to have both real-time reporting and historical reporting,” believes Giles Nelson, director of technology at Progress Software, an application infrastructure software provider.
“You have got the real-time analytics to look for certain patterns of behaviour and one level of analysis to alert you to some obvious and possible market abuse situations occurring. Then you need the further analytical capability of looking at the past, doing a lot more computer intensive analytics and things you are not able to do in real time.”
More than technology
Market supervision through exchanges or market surveillance by the regulator are not initiatives that are solved by merely installing a piece of technology. Effective market surveillance is as much about the processes in place as it is about the people behind the software systems used, and with constantly changing market conditions surveillance systems need to evolve and be updated and refreshed regularly.
Since the early 1990s when the first truly innovative market surveillance systems were used by a few exchanges, markets have changed dramatically with the emergence of new electronic trading capabilities and varied asset class investment. Exchanges are now firmly in the game of making money and in the past decade an increasing number of them have been run as for-profit trading platforms. This demutualisation is having a knock-on effect on the way in which market surveillance can be performed.
The Canadian market is one such example – the Toronto Stock Exchange (TSX) become a for-profit entity in 2000. As with any public company, there are numerous cost centres that cut into the bottom line and at the TSX, market surveillance was one of them. Mike Prior, director of Market Regulation Services, says: “There was a conflict when we went to a for-profit model. The company didn’t know what the perception would be if they started cutting the surveillance budgets, so to eliminate the internal conflict they put the surveillance out as a separate company.”
Market Regulation Services (RS), an independent market surveillance unit for the Canadian equity marketplaces, was formed with the intention of being able to provide third-party surveillance services that Canadian exchanges pay for without the possibility of conflicting interests or differing standards of surveillance across the different exchanges.
Although TSX is a for-profit company, RS operates a cost-recovery model with an equal 50-50 ownership by the Toronto Stock Exchange and the Investment Dealers Association of Canada (IDA). “Our governance is set up so that the majority of our board are independent so neither the TSX or IDA have control – they just have representation,” explains Mr Prior.
A similar initiative was taken towards the end of last year, and finalised in July this year, when the New York Stock Exchange (NYSE) and the National Association of Securities Dealers (NASD) announced plans to consolidate their regulatory operations into a single, self-regulatory organisation called the Financial Industry Regulatory Authority (FINRA). “By eliminating overlapping regulation and establishing a uniform set of rules placing oversight responsibility in a single organisation, we will enhance investor protection,” believes Mary Schapiro, CEO of FINRA.
Derivatives versus equities
Regardless of asset class, the market surveillance systems that exchanges have in place are looking for a similar sort of thing; orders that are being submitted to the market, trades arising from those orders, and positions being held by market participants. The difference in the equities and derivatives markets is the time over which positions are held – in the equities markets positions are usually not held for longer than three days whereas the nature of the contracts on a derivatives market will mean the position is held for longer.
“At a very high level, the systems are looking at the same activity,” says Andrew Dodsworth, director of market services at Liffe. “However, you can probably split this into two categories: the rules that are relevant only to the derivatives market and the rules that relate more to market abuse and are pertinent to all markets in the UK and all markets that are regulated by the Financial Services Authority [FSA].”
This is not to say, however, that there are not differences between regimes in their ability to survey the market, argues Mr Dodsworth. He believes there are interesting differences between the regulatory environment in the UK and the US, especially in terms of client identification.
A member of a market in the US will be assigned a reference number that is kept for all of the US markets that they trade on. In the UK, conversely, different reference numbers are used for different markets. “From an individual market perspective that is not a problem,” says Mr Dodsworth. “But from the regulator’s perspective it makes the job really hard. It needs to be able to tie up the trading activity of [different reference numbers] to see that it is the same client trading on both markets.”
Derivatives trading platforms and other new competitive trading platforms, such as Turquoise, Plus Markets Group and virt-x, are exacerbating the problems for the regulators and causing questions to be asked about who will ensure that a combined view of trading activity is taken.
The emergence of competitive platforms has the potential to fragment the market, and so fragment real-time surveillance in the market. Several platforms and exchanges will only be able to see what is happening on their platform, and those looking to hide insider trading will do all they can to take advantage of these various alternative platforms.
“Real-time surveillance across all markets and instrument classes will be a challenge in both real time and batch mode,” says Brian Taylor, managing director of BTA Consulting, a financial services consulting company. “Regulators will need to link all their systems across markets to ensure there is no cross-border or cross-venue abuse, as well as abuse on or off the exchange.”
The regulator’s response
All the regulators approached about this issue declined to comment, but regulators are responding to this and none more so than the UK’s FSA.
Following research that showed higher than expected volumes of insider, or ‘informed’, trading, the FSA initiated plans to strengthen its surveillance and pursuit of this potential type of market abuse. In June, application infrastructure software supplier Progress Software won the mandate to provide its event processing platform to help in the upgrade of the FSA’s Sabre transaction monitoring system. So far, the FSA has spent £16m on upgrading to its new Sabre II system, which will also respond to the demands of further market fragmentation caused by the Markets in Financial Instruments Directive (MiFID).
MiFID will create a landscape that encourages the development of new trading venues, such as multilateral trading facilities (MTFs), which can be operated by either a regulated market or an investment firm. These trading venues do not have the same obligations concerning financial instruments included into their quotations, and there are no specific requirements regarding the authorisation for the operation of an MTF.
This has given rise to two categories of markets and also two categories of shares – regulated and MTF – and the two do not always coincide. Julia Black, professor of law at the London School of Economics, says that the directive only requires that the MTF operator put in place rules that are sufficient to allow it to monitor its markets for market abuse and compliance with the disclosure obligations. “Market operators could get quite different sets of information depending on the share that’s traded,” says Ms Black.
“This creates the possibility that if MTF venues become more important as primary markets, and/or if MTF trading in any MTF share is to become dispersed across a number of MTFs, this could result in a significant loss of transparency of the MTF markets and for a significant section of the market as a whole.”
Mr Jones, at SMARTS, is not convinced that national regulators will be willing or able to move quickly enough to be operationally part of this burst of new activity. He suggests that one or more independent for-profit international companies could be geared up to provide supervision and surveillance services to new trading venues in a similar way to what has happened in the Canadian market, and more recently between the NYSE and the NASD.
“Regulators could stay principles-based and focus on auditing the activities of the trading venues and these for-profit supervision and surveillance companies,” he says.
Whether an independent body will be established to survey the market in Europe is an interesting debate. Some believe that market forces will dictate this decision; others believe that it is definitely a regulatory issue that European watchdogs have to figure out for themselves.
With increased competition and fragmentation, and increased diversity in asset classes, the job of exchanges and regulators around the world in surveying their markets will become increasingly difficult. These are hurdles that can be overcome, however, and if the recent market crisis is the litmus test for market surveillance systems then they have fared well. As long as serious consideration is put into staff, technology, processes and all the elements of the surveillance programme, then exchanges will be able to keep their markets in good working order and regulators will always be one step ahead of the fraudsters.
