As US regulators continue to scrutinize Morgan Stanley’s block trading business, Matt Smith, CEO of SteelEye, highlights the increasing importance of risk and trading desks collaborating to track the conditions surrounding large trade orders.
From allegedly failing to execute trades at the best price, to clients being misled about the type of trade being executed, block trading has taken its fair share of criticism over the past decade or so. Against this flurry of unflattering headlines, including the Securities and Exchange Commission’s latest probe into Morgan Stanley’s handling of block trades by its US equities desk, it is important to recognize that 99.99% of the time, investors are simply looking to trade away from public exchanges, without deals being displayed until after execution.
No rational market participant would want to invite draconian measures to restrict a form of trading that, overall, lowers costs and holds the prospect of improved outcomes for investors. That said, one can’t ignore the fact that 0.01% of market participants play outside of the rules.
The issue is that any block trade is extremely sensitive to information leakage to a third party. Block trades not yet publicly disclosed are considered material non-public information, and regulators view the sharing of such information as market manipulation since the recipient can “front run” the block trade to trade favorably on their own account.
Any activity undertaken by an “outsider” based on prior “insider” knowledge can damage the outcome for the end-investor. After all, the larger the order and the more illiquid the stock, the greater the likelihood of adverse price movement if a leak occurs.
As an example, if a hedge fund trader who has arranged to execute a block order of 100,000 shares in a little-known small-cap company with a market price of $10 per share, also tips a friend that the trade is imminent – the party receiving the heads up can benefit unfairly from this information by trading in cash or derivative markets in this or correlated stocks.
Tracking such behavior presents a major challenge for risk departments as they won’t normally have any insight into the tip-off, or why the trader in receipt of the insider information decided to execute a trade in the little-known small-cap company that he/she may not habitually trade. This is a significant concern for regulators who have clearly signaled their determination to eradicate such behaviors.
Thus, in a more rigorously policed environment, compliance professionals need to develop improved capabilities around integrative surveillance spanning orders, trades, market activity, and communications. They need to monitor market movements and corresponding communications in a holistic way to identify and investigate potential leakages of sensitive information and unusual trading activity ahead of significant market shifts.
Closer collaboration between front and middle office teams is also important. It is not uncommon for traders to avoid formal supervision, even when they are not doing anything wrong, because they don’t understand or agree with why it is being done. Front-office teams need to buy into the compliance culture of the firm. With middle and front office teams singing from the same hymn sheet, it is easier for compliance teams to establish a view of what “normal” looks like and thereafter monitor for atypical behavior.
Block or dark trading venues keep traditional exchanges on their toes with regards to fees and performance. These venues continue to provide investors with a greater choice of where and how to trade. But with this greater choice comes the need for an enhanced ability within compliance to scrutinize the context and conduct surrounding block trades. With the spread of insider information is much harder to control for block trades, proper supervision of information flow prior to any block trading activity is crucial and this needs to be linked to any corresponding trading activity and market shifts. Collaboration between front and middle office teams is also imperative to crack down on rogue practices.
It, therefore, stands to reason that as demand to trade in large size continues to grow, risk functions should leave no stone unturned when it comes to the detection of market manipulation surrounding block trades, and trading teams need to get fully behind this.
