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Bovill on market abuse in the UK: part 3

Beth Cazalet, The Bovill Group, Consultant, London, 7 August 2015

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Many private banks and asset managers generate trades outwards to their brokers or, if they have direct market access, out to the market. We have already looked at their need to restrict access to inside information. Today we take a practical look at what they should be monitoring.

The UK's Financial Conduct Authority is hoping that compliance officers are going to be its eyes and ears. Although it receives transaction reports of all kinds and at all times, its involvement is a world away from the experience of people who are actually in the market and who are able to pick up on something that does not feel right or seem normal. You, the compliance expert, might think that it is absolutely crazy that such-and-such a price jumps every day at 3 o'clock, but the regulators are likely to be too remote for that thought to occur to them.

The object of the exercise

What are we trying to do when we look for signs of market abuse? What is our goal? I always like to go back to first principles when answering such questions because that is what the FCA does. Indeed, that is what it can fine you for if it cannot find a useful rule; instead it will find a principle.

Your aim is to treat your customers fairly by making sure that your firm and your staff are not taking advantage of inside information, while trying to mitigate your conflicts of interest. Those two things, if every bank did them well, would generally protect the markets from abuse. Obviously, if the markets were to be freed from abuse, people would become more interested in using them. On top of this, if your bank does have good controls, they will protect it from regulatory action and it will look good in 'due diligence' reviews.

The biggest risk

There are several categories of people to look at. These include:

  • the IT contractor who helps with the servers;
  • the portfolio manager who does not do any PA dealing (personal account dealing) because he has “skin in the game" because he owns his fund;
  • the man who “PA deals” frequently but whose requests are often denied; and
  • the sole trader using an HFT (high-frequency trading) strategy.

This last type of person recently used off-the-shelf software and allegedly managed to create a flash crash. We have to consider contractors, we have to consider service-providers and people in corporate finance. We could also consider the broking arm of an investment house; an asset manager using OTC products; secure printers who publish offering documents; or a corporate finance department.

How to identify your risks

You must ask yourself whether you are trying to control flows of information, or whether you are more concerned with market manipulation, i.e. with the way that your firm transacts. For some firms it is both, but if your firm is never out there meeting analysts, or going to briefings, it is possible that information flow is not your biggest priority.

You ought to acquire a good sense of the life-cycle of your investment style, whether that is based on transactions or trades. Who is involved in the decision-making process? Who comes up with the ideas? How are they agreed? Who kills off ideas, and at what point? The answers to these questions will give you the yardstick you need to understand what your norm is. If you do not know what it is supposed to look like, you cannot know whether you are trading outside it.

You should write this information down and incorporate it in your conduct risk strategy. That way, if the FCA has to come back later and ask who knew what, or who was involved in what, you can confidently say “we have an investment committee that consists of Tom, Dick and Harry who review everything; John manages 15% of the risk of the portfolio and he has complete freedom to take decisions about that; this is what we've always gone by; this is the way we do it."

You need not only to understand the areas you have to control; you also have to understand the systems you have in place. These could be investment committees, a portfolio management system, or Chinese walls. You have to understand what those mitigants might be and how you actually are transacting business, whether that be placing deals or any other kind of transactions.

Do you understand the MAR controls that you have in place when carrying out client and PA deals? Do they intersect at all and, if so, how? Just because somebody is a junior analyst, it does not mean that he does not have information. It does not mean that he might not be doing PA deals. One of the things that people often forget, or do not want to include in their PA dealing policies, is the fact that people can easily manipulate the market with spread-betting.

* The next instalment in this series will look at pre-trade and post-trade controls. Beth Cazalet can be reached on +44 (0)20 7620 8440.

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