Covid-19 has certainly put an undue amount of pressure on compliance teams to respond quickly to the changing operational circumstances that it has created. One specific area of concern is the detection and prevention of market abuse when markets are exhibiting extreme volatility and employees are forced to work from home.

This problem is an operational one from which the regulatory agencies have no intention of granting financiers any relief. Indeed, the UK's Financial Conduct Authority still expects firms to be able to detect and report to it about suspected and actual instances of market abuse regardless. In its Market Watch newsletter in May the regulator stated clearly: “We are aware that increased market volumes and volatility have caused a surge in the number of surveillance alerts in a number of markets. We understand that firms are handling this challenge in different ways. Firms should ensure that their approach is tailored to the risks they are exposed to and does not diminish the appropriateness and effectiveness of their surveillance.”

The US Securities and Exchange Commission has said similar things.

This pressure from the regulators only adds to the many problems that financial firms have to solve when meeting their market abuse compliance requirements. There are four main challenges.

1. Higher alert volumes due to greater volatility in markets. When the markets were roiling wildly back and forth in February and March 2020, many trade surveillance programmes sent out thousands of 'false positive' alerts to compliance teams. For instance, in March the average daily trading volumes across exchanges in Europe jumped to €69 billion – a 60% year-on-year increase, according to Cboe Europe data. Volatility also skyrocketed with the Vix index of equity-market volatility, hitting a record high of more than 80 in mid-March. Although it went down to 32 in mid-June, it was still above its long-term average of 20. All told, these extraordinary patterns of trading activity and volatility certainly complicate trade surveillance monitoring. For compliance teams it an administrative headache because it is nearly impossible for them to modify these percentage benchmarks in a way that reduces the volume of alerts while still possessing a modicum of sensitivity that allows them to see signs of market abuse.

In fact, many firms saw the number of market abuse alerts rise to five or six times their normal levels in the early days of lockdown. This happened because their software programmes rely on percentage benchmarks to trigger alerts. This led to a constant stream of alerts that required investigation, which undoubtedly increased their workload.

2. Choosing the correct algorithms. Compliance teams are required to track specific types of market abuses and activities relevant to their business and trading operations by using algorithms that adhere to market abuse regulations. However, it can be tricky to settle on the right algorithms to flag up instances of financial crime or market manipulation. Firms can also find it difficult to monitor events for the correct behaviour, sometimes overstepping or falling short in their trade surveillance efforts.

Algorithms specifically tailored to the task of detecting the many types of market abuse are necessary. For instance, the job of uncovering improper order handling (the act of possessing material non-public information (MNPI) and then using it to execute trades with an intent of gaining advantage) needs algorithms specifically designed to find following/tailgating, front-running, inappropriate allocations, preceding and price outliers. [All slang terms.] Once chosen, the algorithms must then collate and analyse data such as market data, news, client identifiers, order timestamps, cancelled orders, and execution venue information to decrease the number of false positives.

3. Accurately tracking communications. In a recent Market Watch newsletter, the FCA exhorted firms to continue to monitor communication channels for the abuse of MNPI. Considering that many financiers are working from home, the potential for MNPI to either be used inappropriately or for it to escape “into the wild” is significant. In addition, both firms and the regulators are worried that the rise in the use of offensive language by traders working from home might indicate a more careless approach to compliance requirements, thus exhibiting an increase in market abuse activity.

[Editor's note: swearing among traders is sometimes, for some reason, taken by IT men as the sign of a propensity to indulge in financial crime, as is the presence of porn on phones and computers.]

However, it cannot be stressed enough that firms ought to be proactive in monitoring all employee communication channels, as well as being able to detect trading or order placement before or after prices move about significantly. Compliance teams that look for these things should also align trade data with communications information (and other sources such as news and social media) quickly.

4. Preparing the algorithms. It is vitally important to calibrate the algorithms correctly. A compliance team cannot simply press a button on its trade surveillance platform to prepare it for Covid-19 market conditions. The process can be a multi-faceted one. The compliance team ought to conduct a full review of any changes, back-testing data as it goes. It also ought to provide an audit trail to explain why it made the changes and what the results of the review were. It has to make all these adjustments during intense market movements (such as those seen in February and March) and it is almost certainly already stretched thinly.
 
The UK's FCA is making sure that any market abuse that takes place during the current pandemic is promptly tracked down and tackled by means of its new suspicious transactions and orders report (STOR) forms. Previously, firms only used to complete such forms if there were signs of market abuse within their own walls. Now, each firm must send the regulator a “market observation” regarding potential market abuse activity to which it is not a party, and for which it does not have complete information. As a result, compliance teams are under more pressure than ever before to watch the markets correctly.

Interestingly, Bloomberg recently reported that suspicious transactions and order reports that firms sent to the FCA fell in April to their lowest level since the European Union's Market Abuse Regulation or MAR took effect in 2016. The FCA received only 215 reports in April, whereas the number is usually in the 500-600 range. One reason for this is the struggles of compliance teams to manage the volume of false positives and the consequent drop in STOR forms being forwarded to the FCA.

Lastly, current market conditions are creating a range of other compliance hurdles as well, such as the news that both CME Group and Deutsche Börse have decided to discontinue their regulatory reporting businesses. As a result, many compliance teams are reconsidering their overall strategic approach to their regulatory obligations and are moving away from manual or internally created approaches to automated and outsourced services. The beauty of these RegTech programmes is that they might lower costs and enable compliance teams to be more agile in the face of changing circumstances.

* Matt Smith is the CEO of SteelEye, a compliance tech and data analysis firm whose software reports on transactions and keeps records. Visit https://www.steel-eye.com