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Bovill on market abuse in the UK: part 6

Beth Cazalet, The Bovill Group, Consultant, London, 18 August 2015

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It is too expensive for any private bank or asset manager to impose all possible pre-trade and post-trade controls on its trading business. Here Mark Spiers (pictured) and his colleague Beth Cazalet suggest ways in which a compliance officer can make slender resources go further while still pleasing the regulators.

Market abuse falls into six categories of bad behaviour, the worst of which is insider-dealing. In the fight against market abuse, private banks and other firms have a smorgasbord of pre-and-post-trade controls to choose from. These include hard blocks, restrictions and position limits coded into the trade order system, a PA (personal account) dealing approval process, a “second pair of eyes review” before each trade, separation between dealing desks, reviews of trading around market events, reviews of holding periods of PA and client trades, reviews of “outperformance,” and many more. Market abuse may be a one-off event, but it is statistically just as likely to be continual at a firm. Compliance officers therefore have countless things to think of looking out for: people “forgetting” to get PA deals approved, PA dealing in securities that are in this-or-that client's investable universe but not in his client portfolio, and so on ad infinitum. No compliance officer at any firm can follow up all these leads, so how should he choose among them?

Good, better, best practice

The answer, with reference to the old rhyme, is to break tasks down into the three categories of "good, better, best". You may have the resources to fulfil all three; you may be able to climb onto the first rung only.

GOOD

At a good/basic level, make sure that you have written the risks down, drawn up a risk chart, ensured that the staff are properly trained, made sure that you have a PA dealing process and checked that the person in question did the deal that you approved of within the time-frame that you set. At this basic level, you should be ensuring that people are holding on to securities for as long as they are supposed to according to your policy. Too often I see good policies compromised because the compliance people do not bother to check to see whether people are doing what they say they should be doing with those policies.

A clear statement of your investment strategy or rationale for trading decisions is vital. If you rely on automatic systems, review them properly and update them as necessary.

Lastly, make sure that you are looking at trends that are greater than just one event. You should review your MAR risks [pertaining to the Code of Market Conduct, the section in the FCA rulebook known as MAR] regularly, at pre-determined moments such as every time you change staff, or every six or twelve months, whenever your firm enters new markets, or when its products change – all these are good 'triggers.'

Think about how appropriate client trades are and do not be afraid to ask if they do not make sense to you. You might feel a little foolish when you ask the people on a trading desk why something happened, and there is a danger that you might be fobbed off with market jargon. Do not let it happen! If you cannot understand something, there is every chance that the FCA will not understand it either.

You should also remember that derivatives can affect client trades as well. If it is appropriate to your business, you should question valuations of over-the-counter (OTC) products or of other illiquid market products, because (especially if your firm is involved in providing prices for those) that is a prime place for a little market abuse. If someone can affect the price, he might be able to push an inappropriate sale through.

BETTER

If you have the resources to go to the next level up, do make regular attestations as part of your PA dealing-room process. You might write: “I understand the rules and I have reported everything suspicious that I have found.” Even if your staff end up breaking the law, you will then have records that show that you have trained them and reminded them of their obligations and forced them to sign something regularly to prove it. You are therefore going to be in a much better position with the FCA. You will be able to say "I did everything I could possibly do to prevent our people from committing market abuse but I cannot stop somebody who is determined to break the law.”

See whether you can make your IT systems generate some exception reports that you can then walk around with, saying "this has come through, can I just ask you about it?" When you do this regularly, people will stop being frightened of talking to you. It will then be much easier for you to question them when something more contentious comes up.

Lastly, keep revising your surveillance according to the results of your monitoring. If you have found that the information flows are not as vital as you thought they were, or that the Chinese walls are working terrifically and are not the source of your highest risk, move on! Do more monitoring where there is a higher risk.

BEST

What are the very best things that you can do? If you have time, it is an excellent idea to involve your firm's investment personnel in your MAR risk management. Get the investment directors, the heads of tables, the heads of desks and so forth to look at the trades themselves and come to you and talk about it. If you have time, go to the investment meetings and listen. The simple act of taking an informal interest in what they are doing will act as a deterrent to market abuse and will encourage everybody to improve their standards of behaviour.

As we have said before, it is also an excellent idea to review phone calls and chats regularly, just to develop a feel for what is happening here and now. Also, if you have the wherewithal, spend some time considering performance in relation to market abuse. If your bank does high-frequency trading of some sort, then you may have to think hard about investing in sophisticated, advanced software that can review your trades – if they are numbered in the thousands, you can never look at them all yourself. You might be able to look at volume numbers or some headline figures but this cannot be enough.

Widening dangers and criminal liabilities

We have come a long way since a bit of insider dealing was seen as part of the job of stockbrokers. The rules in this area are always expanding and deepening. As we mentioned at the outset of this series, we have the new European Market Abuse Directive, MAD II, also known as the Criminal Sanctions for Market Abuse Directive, on the horizon. This will, when it comes into force, do various things.

  • Widen the definitions of “inside information” and “disclosure.”
  • Standardise the offences of insider-dealing and unlawful disclosure throughout the EU.
  • Widen the applicability of market manipulation.
  • Legislate for market soundings.
  • Contain more requirements for suspicious transaction and order reports (STORs).

Essentially, it widens the scope of the initial market abuse directive in terms of the securities and in terms of the trading venues as well, so MTFs [multilateral trading facilities, a European Union regulatory term for financial trading venues that are not exchanges] are included in various of the offences. Commodity derivatives, for example, are to be covered more thoroughly than they are now. If your bank or asset management firm is involved in market soundings, there will be some very restrictive rules to govern the circumstances in which you may receive inside information. Quite importantly, MAD II promises to widen the suspicious transaction reporting regime to take in suspicious orders as well. An attempt to manipulate a price or do an “inside-deal” is therefore going to be as reportable as the actual transaction that the offender seeks to make.

This will all be coming into effect in July next year. Under the Lisbon Treaty, the United Kingdom is not bound by the EU's criminal laws unless it chooses to opt in. The Chancellor of the Exchequer announced in June 2014 that Britain would not opt in to MAD II and that the government would create new criminal offences instead. The UK therefore has to make some changes to its criminal law, but more or less everything in the accompanying Market Abuse Regulation (which became EU law last year, at the same time as the directive, and which enters national laws with no need for a national legislative vote) will come into force next year. You should also have a quick look at the Fair and Effective Markets Review paper that came out recently for a good indication of the direction of travel that HM Government is planning for our sector.

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