It states that the surveillance process presents several challenges, such as extracting clear signals from the noise of the markets and providing evidence of intent and market abuse without lengthy recourse to diverse sources of information.
One of the key sources of information is communications data, which is traditionally not well-integrated with trade monitoring systems.
The report authors suggest that rather than matching their trader surveillance capabilities to those of the bodies that regulate them – or even their peers – financial institutions are looking to establish their own practices.
Regardless of the approach taken, a key element of implementing a surveillance system is setting the parameters for alerts. To do so effectively, firms need to understand the various types of manipulative activities that might occur.
|Damon Batten, Bovill|
In addition, staff must be capable of analyzing and interpreting alerts. There are various off-the-shelf systems available, but they will only be effective if the firm has individuals with the time and expertise to understand their output.
One of the core requirements of the European Securities and Markets Authority’s (ESMA) Market Abuse Regulation (MAR) is that firms submit suspicious transaction and order reports without delay.
A surveillance programme should have a focus on the ability to reduce false positives, for example by using backtesting/benchmarking and artificial-intelligence – such as machine learning – techniques, suggests Lars-Ivar Sellberg, executive chairman of Scila, which specializes in market surveillance and compliance systems.
“Finally, a firm should recognize that the surveillance programme will by definition gather and normalize an extensive set of data, which can be used for business development as well as its primary purpose of facilitating market surveillance,” he adds.
“Any vendor should make sure to include tools for leveraging data for this purpose.”
While ESMA’s MAR guidance does not differentiate between asset classes when it comes to abusive and manipulative behaviours, surveillance systems have to allow for nuances in market structures and trading conventions among different asset classes, according to Paul Cottee, product manager for OTC asset classes surveillance at Nasdaq.
“For example, to ramp the FX market, a rogue trader might need to place orders and trade across a number of venues, whereas in equities the manipulative activity might be more concentrated,” he says.
“Another difference is whether or not an asset class is normally centrally cleared, as the necessity of bilateral credit lines may determine what trading channels are available.”
Advantage of venues
The FICC Markets Standards Board observes that venues bring a broader surveillance perspective to the industry and have the potential to identify market-wide issues earlier than individual firms due to their access to data.
An FX trading venue will typically be required to have comprehensive rules to give operational effect to statutory regulations and for the efficient working of the market. One example is a statutory ban on wash trades – an account trading with itself across a venue – to prevent fictitious trades.
|Paul Cottee, Nasdaq|
The venue might enforce this operationally by imposing rules as to how opposing orders are to be handled – such as a minimum time between the entry of a bid and an offer by or for the same client – explains Cottee.
“Such operational matters might take on the patina of regulation in that any breaches of venue rules may need to be reported up to the statutory regulator,” he says.
It is vital that firms pay close attention to the guidance provided by the trading venues in which they participate. If a firm were to begin transacting in a new type of instrument, it would be prudent to evaluate the type of manipulative activity that could occur in that instrument and adjust the settings of its trade surveillance system accordingly.
“In regard to regulation, firms can incorporate regular checks of any relevant changes directly into their compliance monitoring programmes,” adds Bovill’s Batten. “This can be performed internally or with the assistance of an external adviser.”
Firms can ensure surveillance does not negatively impact day-to-day operations by properly mapping client data and truly understanding how they transact and the asset classes they trade, suggests Michael Lehman, partner at ACA Technology Solutions.
This approach will produce quality items of interest and not just report on misleading activity, he adds.
“The old methodology was to generate large exception-based findings,” says Lehman. “Proper surveillance de-noises that by adding multiple steps to the algorithm before reporting those findings to the client.”
In addition, due to the multiple additional obligations on firms around record keeping, reporting and analysis as part of Mifid II, it is prudent to combine solutions that also provide modules for algo monitoring, market maker compliance, best execution and transaction cost analysis, says Johannes Frey-Skött, vice-president apps engineering at electronic trading technology developer Itiviti.
“If this can be system agnostic, the investments companies need to make for compliance can be significantly reduced,” he concludes.