Last year saw a surge in markets abuse fines and high profile cases of deceptive trading particularly from large investment banks.
“As financial markets have become increasingly complex, so have the forms of market abuse we’re seeing,” said Mike Coats, Chief Technology Officer, TradingHub.
“Manipulators have developed more sophisticated methods that often span multiple financial instruments and trading venues,” he told Traders Magazine.
“Virtually every sell-side trading desk makes money as a cross-product desk, so these intricate – and more complex to capture – forms of abuse have become a growing problem,” he added.
Coats said that regulators have been sending a clear signal that banks need to have a handle on these more advanced forms of manipulation, such as cross-product abuse and abuse in the primary markets.
“In our recent conversations with regulators, they have underscored this position,” he said.
Last year was also the first year that FINRA included market manipulation in its annual Examination and Risk Monitoring Program, a clear signal that regulators recognize it as a growing threat and now expect market participants to have robust surveillance processes in place, Coats said.
Regulators like the CFTC and SEC’s Market Abuse Unit are increasingly responding to this kind of illicit activity, resulting in large investment banks or buy-side firms incurring huge regulatory penalties, damaged reputations, and costly operational disruptions, he added.
According to Coats, many banks’ approaches to trade surveillance are decades out of date.
Most now have a good handle on simple abuse types like single instrument spoofing, but traditional trade surveillance solutions are reliant on single-venue monitoring alone, he said.
“This is like trying to spot a shooting star by looking through a keyhole. You’re not likely to see it, because you’re not looking at the whole sky,” he stressed.
According to Coats, banks’ surveillance models need to significantly expand the lens they’re looking through so that they can capture the instances of high-risk manipulation – which are going to involve cross-product abuse strategies and are likely to span both lit and OTC markets.
“Looking at transactions independently always misses the full picture,” he noted, adding this is because buying one instrument and selling a related one – albeit elsewhere on the markets – is a position in the spread between the two, not two independent positions.
“So monitoring trades in isolation leaves banks with an onslaught of expensive false alerts, but still misses the severe cases of wrongdoing that end in fines. And with regulatory actions in this area increasing, banks are out of time to get a handle on the risks,” he added.
Coats said that cross-product abuse is happening everywhere.
The market is only just beginning to develop its understanding of how cross-product abuse is occurring in places like the fixed income space, but the problem doesn’t stop there, he said.
This form of manipulation exists across all asset classes, from equities, to commodities, to FX – across complex OTC markets, as well as exchanges, he added.
“Most traders are thinking and acting in cross-product terms, so if a bank is not looking for the cross-product impact of any trading action – whether that trade is in equities, derivatives or another instrument – then that bank has a critical gap,” Coats said.
“This is the primary reason why so many banks are being caught off guard by highly damaging actions and fines,” he added.
Some of the most high profile cross-product abuse cases of late are JP Morgan’s fine of $920 million for spoofing in US Treasuries and Precious Metal Futures, and Deutsche Banks’s fine of $130 million for spoofing in Treasuries and Eurodollar Futures, Coats said.
Overcoming challenges in trade surveillance
Traditional trade surveillance systems are applying an overly simplified rules-based approach that doesn’t match how today’s traders actually think and behave, according to Coats.
This means the riskiest forms of market manipulation are happening in places where these systems are not capable of spotting until it’s too late, he said.
“Meanwhile, these systems are throwing up a barrage of false alerts that can cost millions just to investigate. It’s unsustainable,” he added.
“What’s needed is to re-approach trade surveillance with a front-office mindset, because the riskiest instances of manipulation can only be identified if we apply Market Impact Modelling – a trading floor way of thinking,” he commented.
According to Coats, Market Impact Modelling can show how a trader’s positions across a combination of assets and markets are interrelated and share risk commonalities, and it can therefore enable banks to detect highly intricate instances of abuse.
This method also reduces false alerts dramatically and ensures the highest risk cases can be investigated first, he said.
If a bank truly wants to safeguard itself against costly fines and lawsuits, some of which can even come down on individuals at the executive level, then its trade surveillance approach needs to reflect how traders genuinely think and trade, Coats pointed out.
He said that surveillance systems need to use the same mathematical models that traders use and apply those to understand the market impact of any trade – identifying matching hedging activity and correlating impact across multiple asset classes, throughout both exchanges and OTC venues.
“This is the only way to detect the otherwise hidden forms of manipulative activity that pose the biggest regulatory and financial risks to banks today,” he said.
“Banks need to flip their approach to surveillance so that it actually aligns with the fundamental business model of trading, and so that it matches what regulators are clearly asking for – which is for them to get a handle on the cross-product abuse problem,” he concluded.
