By Andrew Waters, Global Head of Regulatory Affairs, TradingHub
Whether it is high-profile enforcement actions or the emergence of more sophisticated manipulation threats and tactics, today’s commodities market manipulation landscape is a far cry from that of yesteryear.
Gone are the days where investment bank regulatory, risk and compliance teams only needed to have their eyes peeled for the “same-old” single asset spoofing that dominated the commodities manipulation landscape for decades. Instead, these professionals are needing to come to grips with a significantly more diverse and advanced commodities manipulation environment; one that is seeing abuse spread across venues and assets. And as the temptation to squeeze prices for large futures contracts ahead of agreements surges, the OTC commodities market will only continue to grow riper for manipulation, not less so.
This has created a daunting problem for investment banks to solve. Not only is abuse activity becoming more complex, but it is doing so at a time where the regulatory community has shown that it is not afraid to flex its muscles when it comes to enforcement.
Now is the time when investment banks need to not only step back and reassess the evolving commodities manipulation landscape that they find themselves in, but also their own trade surveillance operations, what gaps may exist and, most importantly, the steps they can take to solve them.
With that in mind, here are several key items investment banks need to keep in mind as they prepare for the dawn of commodities manipulation 2.0.
The cross-product manipulation wakeup call
Over the last decade in particular, cross-product and cross-venue abuse has quietly become a major thorn in the side of trade surveillance across asset classes. Previously most closely associated with fixed income – given how easy it is for manipulation of one price to impact multiple instruments – cross-product manipulation is now a firm fixture in all asset classes, from equities and foreign exchange to commodities. This creates a particularly dangerous risk landscape for banks as cross-product strategies are a central cog in how nearly every sell-side desk makes money – for example, in the practice of off-setting risk from illiquid client-transactions with benchmark or listed products. As instances and opportunities for cross-product manipulation continue to rise, banks are still having issues detecting cross-product abuse because they are still not deploying strategies that are capable of accurately assessing the risk sensitivities shared between assets in a trading action. Risk and compliance teams must adapt to a whole new threat ecosystem that banks have yet to effectively reckon with, and clearly underlines why a reset in trade surveillance methodologies, tactics and tools is needed.
Doing away with rules-based systems
Historically, trade surveillance tools have been predicated on a slew of pre-set rules that are designed to flag any instances where a trader is intentionally trying to manipulate instruments to their advantage. In theory, this makes sense. But in practice, it has become not just unwieldy, but ineffective.
Because these rules-based systems cast such a wide net in order to catch every instance of potential manipulation, a mountain of mostly false alarms are created for surveillance teams to sort through. More importantly, not only does this result in a huge amount of wasted time and money but it creates an environment where surveillance teams simply do not have the bandwidth to be as thorough as they would like to be against growing backlogs, increasing the risk of manipulation instances slipping under the radar. Rules-based trade surveillance methodology is losing its relevance to today’s market structure. We need to find ways to truly measure the market impact of trades involving commodities.
Adopting a trading floor surveillance view
Investment banks face a true make or break moment because their trade surveillance paradigm is facing a true make or break moment: either adapt and innovate or run the risk of falling afoul of regulators and get accustomed to a heaping pile of fines and reputational black eyes.
This will not be an easy transition. The sophistication of financial markets has compounded in the past five years alone. Legacy systems have proven that they can no longer be relied on to capture instances of suspicious activity, and simply bolting on to what is already in place will likely only complicate matters and make surveillance more challenging. Instead, if investment banks are truly serious about tackling these emerging challenges, they need to take a much broader approach whereby not only do they revamp their technology capabilities but shift their entire strategy to a proactive approach that is informed by a trading floor view.
Traders think in a way that today’s surveillance systems simply do not: in terms of risk sensitivities, not rules. Because of the interconnectedness of commodities, suspect trades in a certain instrument will likely form part of a broader abusive strategy. Rather than treat instances individually, a sophisticated surveillance system should look to group them together creating a much more informed risk map versus a scattershot of individual instances. The most advanced risk-based method would detect instances like the episode in 2020 when the CFTC fined JP Morgan $920 million for manipulating the price of precious metal and US. Treasury futures contracts via an unlawful spoofing scheme.
Having this type of view will help trade surveillance teams establish a much clearer throughline of commodities traders’ positions to see if they are involved in not just single asset manipulation but perhaps a much broader cross-product scheme. Moreover, a surveillance system that has the ability to break risk down into its constituent parts helps compliance and risk teams save time and money by prioritizing higher value alerts.
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This is not your grandfather’s or even your father’s commodities manipulation world. Simply put, today’s manipulation is far more advanced, and regulators are far more forceful when doling out enforcement actions. Moreover, while simply using technology to help mitigate trade surveillance risks might have been enough to appease regulators five or 10 years ago, regulators now mandate that businesses are effectively using technology in a proactive and progressive way to avoid manipulation. The sooner investment banks embrace this new “way of doing business” the better chance they have to avoid regulatory hot water, and the better chance they have to carve out their trade surveillance as a key differentiator among competitors.
