In May, FCA Market Watch 79 discussed failures in market abuse surveillance attributed to issues with data, automated alert logic and testing of surveillance models. The FCA believes that firms may find these observations useful for enhancing the implementation, testing, and oversight of their technical systems for market abuse surveillance, thereby reducing the risk of failures. Here’s a recap for busy professionals.

 

The requirements under UK MAR

“Under the Market Abuse Regulation (UK MAR), firms must identify and report instances of potential market abuse. A firm must have effective arrangements, systems and procedures in place to detect and report suspicious activity. These should be appropriate and proportionate to the scale, size and nature of their business activities.”

 

Examples of market abuse surveillance failures

  • Poor testing: Firm A adopted a new surveillance system to detect insider trading, but failed to activate the essential news feed, resulting in no alerts being generated for over three years. The issue was only discovered when the FCA inquired about potentially suspicious trades that had not been reported.
  • Flawed alert logic: Firm B implemented an in-house surveillance model to detect potential insider dealing in corporate bonds, but a coding error meant an alert would only trigger if the firm itself traded on the day of a significant price movement. This flaw was particularly problematic for less frequently traded bonds, where it could lead to undetected insider dealing. The error went unnoticed for years because the model still generated a reasonable number of alerts, leading the firm to believe it was functioning correctly until a compliance check revealed the issue.
  • Incomplete data feeds: Firm C offered some clients direct market access (DMA) to certain trading venues, and other clients sponsored access (SDMA) whereby the client trades directly on the exchange as opposed to connecting through Firm C. SDMA activity was captured for the firm’s surveillance system using a private order feed (POF). Firm C incorrectly believed it had arranged for all POF data to be ingested and processed by its surveillance system but the POFs for one venue were omitted. This went undetected for several years, perhaps because non-POF trades were generating alerts and providing false comfort that surveillance on the venue was working as intended.

 

Good practice checklist for automated surveillance model testing

The FCA undertook an assessment of how investment firms review their automated surveillance models. We have used the key findings to create a good practice checklist for firms below. These should be adapted to ensure they are appropriate and proportionate to the scale, size and nature of a firm’s business activities.

  • Formal policies and procedures describing and justifying: (i) testing frequency; (ii) the elements of the model subject to review; and (iii) the form of the review.
  • Periodic testing of: (i) parameter calibration; (ii) model logic; (iii) model code; and (iv) data (comprehensiveness and accuracy).
  • Clear ownership and management of data.
  • Arrangements in place to identify, prioritise and remediate issues based on risk.
  • Appropriate and independent assurance that any third party surveillance systems are operating as intended.
  • Testing by the second line and internal audit to assess the effectiveness of monitoring.
  • Regression testing undertaken when changes are made to other systems that might adversely affect market abuse surveillance systems.

 

Conclusion

The FCA states “our observations indicate that not all firms have been allocating adequate focus and resource to governance arrangements.” “We encourage firms to review the issues discussed in this Market Watch and consider whether their arrangements are adequate or need improvement.”

Market abuse surveillance is a complex challenge for all firms, and especially for those operating diverse business models. The tailoring of alert models is essential for an effective surveillance programme, but this will often increase the operational risk at alert level.

 

How C&G Can Help

We offer a Market Abuse Surveillance Health Check to provide insights into the effectiveness of your surveillance arrangements. Contact us today if you need assistance in this area.

 

References

2024. Market Watch Newsletter 79. Financial Conduct Authority. Available at: https://www.fca.org.uk/publications/newsletters/market-watch-79 (last accessed 4th June 2024)