By Tony Sio, Head of Marketplace Regulatory Technology, and Michael O’Brien, Head of Trade Surveillance Technology, Nasdaq
The process of safeguarding marketplaces has drastically transformed in recent years as the trading patterns of the average investor continuously evolve. The financial markets are becoming more accessible to a new generation of enthusiastic retail investors, new technologies are enabling frictionless transactions, and other factors like the Covid-19 pandemic are fueling increased market participation and trading volumes to unparalleled levels.
While the easy market access and the growth in market participation certainly is a positive trend, surveillance professionals tasked with monitoring the market structure grapple with the challenges of designing and developing surveillance systems that can detect market abuse and irregularities in rapidly changing marketplaces.
Whether or not the high trading volumes will subside, we believe that the rise of the retail investor is here to stay. While it is a positive progression, the growth in retail participation does not come without risks for both investors and institutions. Investor protection and market integrity go hand in hand. Ultimately, manipulation is manipulation, whether the perpetrator is an institutional or retail investor. While manipulative behaviors can occur within both categories, the manner in which they take place could be vastly different. Regardless of the type of investor, surveillance practitioners will monitor for key behaviors such as spoofing, layering, marking the open or close, insider trading, wash trading or churning, and pump-and-dump schemes. Yet as surveillance experts and technologists, we can’t embrace the structural changes of the financial ecosystem and the booming retail investor participation without acknowledging that retail investors have different demands and knowledge than seasoned institutional investors. That journey begins with educating retail investors while strengthening our surveillance programs and technology to accommodate the evolving ecosystem in order to uphold the integrity of the marketplace. We need to adapt in order to future-proof our surveillance processes and technology infrastructure, two critical components of well-functioning and fair capital markets that protects its participants.
How can market operators keep expanding access while keeping markets safe for all investors? How can surveillance practitioners detect abnormal behaviors and anomalies in trading patterns in a digital age where new types of investors are changing the typical investor behavior and market conditions?
They can start by educating and monitoring for six key behaviors that threaten to undermine market integrity: spoofing, insider trading, layering, wash trading / churning, open or close marking, and pumping and dumping. Surveillance teams closely monitor for these key behaviors, and by understanding the basics, individual retail investors can as well:
· Spoofing – when orders are entered with no real intention of trading, but rather with the purpose of feeding misleading information about supply and demand.
· With layering, traders enter orders at different price points to give market participants a false impression of supply and demand.
· Marking the open or close means that traders try to set the opening or closing price.
· Insider trading occurs when an individual is in possession of material nonpublic information about a company and uses it for their own gain when trading.
· Wash trading, also known as churning, can happen when a trader excessively buys and sells securities to feed misleading information into the market.
· The pump and dump happens when a trader attempts to increase the price of a stock through buying activity or the dissemination of misleading information.
Technological advances, zero commissions and fractional shares have led to a major shift in the demographics of market participants – which, combined with the influence and widespread of social media, has resulted in complex and varied market conditions. While surveillance analysts need to adapt to a new type of investor profile, retail investors need to educate themselves to attain a high-level understanding of these concepts, in order to not be misled into investments they are not prepared for.
Firms must prepare and adapt to the retail wave and digital age that is here to stay. As surveillance practitioners and technologists, we need to remain diligent and use the technology that is available to us to automate processes allowing us to utilize the best possible infrastructure for market safety. Education is equally important – however, retail investors are invaluable market participants and are ultimately responsible for their own investment decisions, and therefore need to watch out for the behaviors that threaten success.
When markets operate with transparency and integrity, all types of investors are better equipped for success.
