Newsletter on market conduct and transaction reporting issues.
About this edition
In this Market Watch, we discuss firms’ arrangements for market abuse surveillance, drawing on our observations from engaging with small and medium-sized firms. While the topics covered apply to all firms subject to surveillance requirements under Article 16(2) of UK MAR, they may also be particularly relevant for firms with less complex business models. We also discuss some observations about obligations involving policies and procedures to counter the risk a firm is used to further financial crime, specifically criminal market abuse, as per SYSC 6.1.1R. Lastly, we discuss investigations into potential market abuse by firms’ employees and when firms should submit a STOR.
In previous Market Watch issues (48, 50 and 56), we discussed our observations from our ongoing programme of STR/STOR supervisory visits to firms. As well as visits, our supervisory work involves other types of engagement, one of which is the periodic sending of a STOR questionnaire, which we have done several times since 2014. We consider it is now helpful to discuss some of the recurrent themes and observations from the responses to the questionnaires and our subsequent follow-up work.
Identifying and reporting instances of potential market abuse is required under the Market Abuse Regulation (‘UK MAR’). A firm must have effective arrangements, systems and procedures in place to detect and report suspicious activity, which should be appropriate and proportionate to the scale, size and nature of their business activities. While it is for firms to assess what is appropriate and proportionate in the context of their specific business, some of the observations in this Market Watch may be useful.
Market Watch – Observations on market abuse surveillance
Market abuse risk assessments
We have previously discussed the benefits of a comprehensive, accurate and up-to-date market abuse risk assessment and how it can help ensure effective surveillance coverage. Where firms do undertake such an assessment, we have observed a range of methodologies and ways of presenting the end result. In our experience, the most effective assessments involve consideration of the different types of market abuse and how they apply across different areas of the business and asset classes. While we continue to see good examples of work in this area, we have observed some firms that are less effective at identifying the market abuse risks to which they are exposed.
Some firms consider market abuse at a high level, as a single risk. Some do so across the firm as a whole, while others look at the risk by desk without assessing different types of market abuse. In some cases, firms conduct a combined assessment (an enterprise risk assessment), which considers market abuse along with other types of risk, such as credit and AML. Others assess only insider dealing and market manipulation, without considering how different levels of risk might apply to different sub-categories of these, such as layering and spoofing, wash trading and ramping.
Similarly, some firms whose business involves activity across a range of asset classes fail to distinguish between them when assessing for risk. Others do not consider how different types of business activity, such as discretionary vs execution-only, or client vs house trading, might present different market abuse risks. Some firms do not consider the method of execution (eg electronic vs voice-broked markets) or the nature of the platform where the trading takes place (eg lit vs dark books, central limit order book vs auction). Some firms completely discount the risks in certain business areas because of low trading volumes, without considering the inherent risks.
Where firms do not consider different types of market abuse, the different areas of business in which they operate, how that business is undertaken, and the different asset classes and instruments traded, they may not be able to adequately identify market abuse risks and align their monitoring programme to them to ensure effective surveillance. This may also be the case where firms do not review and update their systems as necessary to ensure they remain effective in the context of risks arising from changes in their business.
Order and trade surveillance
Our interactions with firms indicate that surveillance arrangements are improving across industry, however, there continues to be variance. While we have seen examples of comprehensive, tailored systems, accurately aligned to risk assessments, we also saw instances of little or no monitoring taking place. Additionally, where monitoring is undertaken, there are elements of it that may hinder effectiveness.
We observed that some firms consider the different characteristics of different asset classes and instruments, before applying this information to calibrating alert scenarios. This means they can ensure they can effectively identify potentially suspicious activity, while perhaps reducing false positives. Other firms, however, apply generic calibration across (and within) asset classes, where the nature and scale of the metrics involved (eg price movement) are significantly different. As an example, for a change in price in an AIM-listed stock, a FTSE 100 stock, a government bond and a corporate bond to be considered notable, and worth review, the size of the move is usually quite different. So, if a firm uses a common threshold in its alert scenarios for all instruments, it may struggle to ensure effective monitoring (the threshold is set too high/too low for some instruments), or it may generate a high amount of ‘noise’ (the alert is calibrated to the most sensitive of the instruments).
Our experience indicates that third-party system functionality in areas such as tailored calibration has progressed in recent years. However, sometimes firms are unaware of these developments and so may not be making best use of the technology. More generally, where firms use vendor-supplied systems, they should ensure they understand how alert scenarios work, otherwise they may fail to identify gaps or weaknesses in their surveillance.
We observed that some firms, even when they have identified insider dealing as a key risk and monitor for it, inhibit the surveillance system’s effectiveness by applying inappropriate thresholds to calibration. The most significant example involves ‘lookback periods’ for insider dealing. We have seen a small number of firms that only alert on trading that has taken place 24 hours before the release of inside information (the ‘lookback period’), without considering the time the information might exist before its release. Proper consideration of the surveillance thresholds will help ensure appropriate and proportionate surveillance.
We observed instances where firms are not monitoring all orders and trades, including cancelled and amended orders. The surveillance of orders, particularly those that do not result in a trade, can be critical in identifying certain forms of market manipulation, such as those that involve false or misleading signals to other market participants.
We have seen some firms with weaknesses in their review of surveillance exception alerts. For example, only escalating and considering reporting where they identify an obvious link between the client and the issuer or source of the inside information. While the existence of such a link may be an aggravating factor in assessing whether reasonable suspicion of market abuse has been reached, its absence does not necessarily serve as sufficient mitigation to close alerts.
We have observed firms using either an in-house solution, a vendor-supplied solution or a combination of both for trade surveillance. While all of these can be effective when implemented and used appropriately, we remind firms of the importance, and regulatory obligation, to periodically review their arrangements to ensure they remain effective. This will include surveillance alert parameters and logic, as well as work undertaken on the analysis and escalation of alert output.
Policies and procedures
Where firms have created policies and procedures in relation to monitoring for market abuse, we have seen a variety of approaches. Some have clear, detailed and up-to-date policies and procedures and it appears these may provide a helpful reference point for staff and assist with work in areas such as alert review and escalation.
We also observed instances where policies and procedures are vague or have limited detail, such as directing analysts reviewing surveillance alerts to look for signs of market abuse, but with no guidance on what these signs might be, or what materials / information to use or consider. Where there is no such guidance, we noted examples where the information considered in alert review may be insufficient or incorrect, and alerts may be inappropriately closed rather than escalated. We also observed that firms with vague or undetailed policies and procedures sometimes struggle to ensure a consistent approach. While firms may be wary of being over-prescriptive, and may want to encourage initiative in their staff, they may want to consider if there are benefits in creating policies and procedures that provide a level of guidance in how work should be undertaken.
We observed that some firms, notably where they are part of a larger group with operations overseas, outsource aspects of their surveillance to another part of their organisation, or to a separate organisation. We recognise that there may be organisational benefits in these arrangements. However, in some cases, there is a limited understanding and / or oversight of the surveillance taking place. This includes inadequate knowledge of alert logic and calibration; weak or no quality assurance work on triaging alerts; and insufficient management information (MI). In a small number of cases, we found that UK Compliance teams had negligible understanding of the surveillance undertaken at group level, and having investigated following our queries, discovered the surveillance was ineffective for the UK business. UK MAR does not preclude such arrangements, but the responsibility for identifying and reporting potential instances of market abuse to the FCA rests with the UK entity subject to UK MAR obligations. To ensure that all aspects of surveillance are appropriate, adequate oversight and governance over arrangements are critical. We remind firms that where there is delegation to a separate organisation, the person delegating should have sufficient expertise and resources to oversee the services provided.
We observed some firms where responsibilities for market abuse surveillance rests with both the front office and an independent Compliance function, performing monitoring separately from the business. This approach may help ensure surveillance is undertaken free from conflicts of interest. Some firms deliver regular, tailored training to front office staff to help them understand market abuse and their role in escalating potentially suspicious behaviour, as per UK MAR.
We observed some firms that place a reliance on front office staff to identify potential market abuse, sometimes giving them sole responsibility for monitoring. In other instances, firms cited front office’s role as mitigation for a limited or absence of surveillance in Compliance. In those cases, this leads to several risks: that all potentially suspicious activity is not consistently identified and escalated; that staff know when trading activity might be escalated and might share that knowledge with clients; and that staff whose remuneration is linked to client business might be conflicted in considering whether to escalate.
The size of some firms may mean staff performing dual roles in the front office and as part of Compliance. Where this is the case, these firms may want to consider whether they have adequately assessed any potential conflicts of interest and taken steps to mitigate them.
To ensure staff act appropriately, firms should consider whether their market abuse training is effective and tailored to the risks associated with the desk, asset classes traded, client types and other relevant factors. Front office staff may also benefit from clear escalation policies and senior management support in helping them in making appropriate decisions.
Investigations into potential market abuse by firms’ employees
We have seen instances where firms identify their own employees undertaking potential misconduct / market abuse. We understand that on such occasions, firms may want to carry out a more detailed investigation than they would do if a client or counterparty was carrying out the potential misconduct / market abuse. In such cases, firms may want to determine whether steps such as disciplinary measures might be appropriate, while taking care not to inform the subject of the STORs or anyone else who is not required to know, that a STOR will be submitted. We remind firms subject to Article 16 of UK MAR that they should also consider the requirement to submit a STOR without delay, once they have a reasonable suspicion that the relevant conduct could constitute market abuse. This may be before the full internal investigation is concluded. If appropriate / necessary, any information not available at the time of the submission can be communicated to us at a later date.