The UK Financial Conduct Authority (“FCA”) published its latest Market Watch newsletter on 26th April 2023, following a market abuse peer review of firms offering Contracts for Difference (“CFDs”) and spread bets (“CFD providers”). Many of the findings are equally applicable to firms offering other financial instruments. This article provides a summary of the key takeaways.
All firms identified insider dealing in single stock equities as the primary market abuse risk. However, not all firms could demonstrate that they had considered other market abuse risks, and how those risks vary depending on the trading platforms or trading methods being used.
A Market Abuse Risk Assessment (“MARA”) is an effective tool for firms to understand how they are at risk of facilitating market abuse. The most effective MARAs identify specific forms of market abuse and the impact that different characteristics can have on the risk profile of the firm’s business model e.g. trading access, strategies, client profiles, asset classes and liquidity.
Responsibility for surveillance
All firms had market abuse surveillance policies and procedures covering the investigation and escalation of alerts from a surveillance system. Responsibility for surveillance varied across firms from the front office to the compliance function. The most surprising finding was that only one firm was undertaking quality assurance checks on reviewed surveillance alerts.
Where smaller firms choose to give individuals outside of the compliance function responsibility for surveillance, they should consider potential conflicts of interest. Independent quality assurance on alert handling is likely to result in more effective surveillance arrangements.
All firms within the review used an in-house solution for insider dealing surveillance looking at one or more of price movement, profit and news events to trigger alerts. There was a material difference in the lookback periods ranging from 30 days to as little as 24 hours.
Most firms relied upon trading desks for market manipulation surveillance with little or no oversight from Compliance. Most firms did not have effective surveillance for non-equity financial instruments.
The three key takeaways relating to surveillance systems are:
- Insider dealing alerts should monitor for unrealised profits as clients will not necessarily close positions quickly.
- The lookback period used for alerts should be based on an assessment of how long inside information is likely to exist.
- Firms should ensure they have adequate surveillance coverage for market manipulation across all relevant asset classes in addition to their inside insider dealing surveillance for equities.
Narrowing the spread
The FCA believes that a type of market manipulation known as “narrowing the spread” is becoming more prevalent. The regulator’s definition of narrowing the spread is set out below:
“This activity aims to influence the prices of spread bets or CFDs by narrowing the spread in the underlying market, typically in illiquid stocks. Orders are placed on the order book via a direct market access (“DMA”) broker (using either CFDs or cash equities) to buy (or sell) a security at prices higher (or lower) than the current best bid (or offer). This narrows the spread of the security and leads to a change in the execution price of the CFD or spread bet, which is based on the underlying instrument. The same (or connected) participant then trades in the opposite direction, in larger size, in a related derivative such as a CFD, often at another broker, benefiting from the improved price. The DMA order is typically cancelled before it trades.”
Despite most firms being aware of this activity, none listed the behaviour in their MARA and none had compliance-based surveillance tools to detect it.
If firms identify a market abuse risk, a complete and accurate MARA would document the risk. Where DMA clients are improving the best bid/offer and rarely executing, particularly if using very small order sizes, it may be an indicator of them narrowing the spread.
Surveillance alert investigations
Some firms placed significant weight on factors such as option volumes, blog articles, analyst recommendations and stock sentiment when reviewing insider dealing alerts. The FCA observed these factors being used as the sole mitigation when closing an alert, without considering the client’s trading history. Some firms captured client IP addresses and advertising IDs to identify potential collusion or links with previously off-boarded clients.
The factors mentioned above can help create a picture of a client or event, but they should also be considered alongside the client’s trading history. It is important that firms record the rationale behind any mitigation when investigating alerts.
IP addresses and advertising IDs can be useful tools to identify suspicious clients and connections. Formalised procedures for alert investigation and escalation can help ensure consistency from the surveillance function, which is particularly important where firms experience rapid growth, diversification or high levels of compliance staff turnover.
Front office and the tipping off risk
There were three main observations from the FCA regarding tipping off:
- Compliance was reluctant to provide feedback to front office staff on surveillance matters due to concern about tipping off.
- Front office staff were reluctant to refuse an order from a client or execute a trade, even if they believe the client was seeking to trade manipulatively or based on inside information.
- One firm routinely involved front office in STOR submissions without considering whether they need to know.
The submission of a STOR should only be shared on a need-to-know basis. This does not prevent Compliance challenging and educating front office staff where they have failed to identify or report suspicious behaviour in their role as the first line of defence.
If front office staff believe a client is seeking to trade manipulatively or based on inside information, they should refuse to accept that order and escalate the incident to Compliance to consider if a STOR for attempted market abuse is required. A STOR submission must never be disclosed to a client.
Countering the risk of market abuse-related financial crime
Firms were typically undertaking monitoring and being proactive in either exiting or restricting clients of concern. Firms adopted a variety of monitoring techniques, with some automatically offboarding clients that trigger a certain number of STORs, whilst others reviewed any client account involved in a STOR on a case-by-case basis. The decision to offboard or restrict clients sat with Compliance or a committee independent of senior management in most cases.
A firm’s framework countering the risk of market-abuse related financial crime should be proportionate to the nature and scale of the firm’s business. The most effective policies have the following characteristics:
- both quantitative and qualitative monitoring are used, with a “common sense override”;
- there is a formal structure to allow for consistent, appropriate and prompt action;
- responsibility for decision-making to offboard or restrict clients sits with Compliance or a committee independent of senior management and free from conflicts of interest; and
- there is adequate record-keeping of decisions to retain, restrict or offboard clients.
How C&G can help with market abuse surveillance support
Market abuse remains front and centre of the UK regulator’s focus. We are well placed to assist firms with their surveillance frameworks. We offer health checks on surveillance programmes, STOR policies/procedures and bespoke training solutions to firms and venues. Contact us with your requirements if you need assistance in this area.