Originally published in Risk.Net
Joe Schifano, global head of regulatory affairs at Eventus, examines how volatility resulting from the Covid‑19 pandemic has made markets more susceptible to insider dealing activity, prompting regulators to urge firms to reinforce surveillance measures as their existing methods may no longer be sufficient
Financial markets have always been vulnerable to manipulation. The temptation to use insider information to sway stock prices and book profits illegitimately is a persistent one.
Notable insider trading incidents – and, on some occasions, other types of securities fraud – have taken place in times of market upheaval.
The US Securities and Exchange Commission (SEC) was created in 1934 in the aftermath of the 1929 US stock market crash. In fact, revelations of the earliest known stock market misconduct led to a revision of the 1933 Securities Exchange Act to specifically prevent and prosecute incidents of insider trading.
The term ‘insider dealing’ came to be used in British law around the 1980s. Legislation was finally passed, and sections 69–73 within Part V of the Companies Act 1980 were enforced, making insider dealing a criminal offence from then.
Despite regulations, corrupt actors have found ways to be creative. During the global financial crisis of 2007–08, one of the biggest insider dealing scandals emerged in the UK, whereas several hedge funds were caught accessing insider information through expert networks in the US.
Although laws have been in place and both trade and communications surveillance have evolved, the methods of circumventing the law have outpaced regulation.
Regulators across the board, led by the SEC and the UK’s Financial Conduct Authority (FCA), are alert to the problems and have issued new guidance. But the onus is on financial firms to recalibrate their systems and adopt new technology to keep suspicious activity in check.
Heightened market volatility and disruption to business as usual – especially during the pandemic – have increased the opportunities for insider dealing. Financial pressures, psychological stress and a perceived lower risk of apprehension increase the prospects of employees succumbing to temptation, without the proper risk controls and technology in place.
The proliferation of communication channels, mobile devices and encrypted messaging services such as WhatsApp have made it easier to share information covertly, without detection. The rise of varied data sources has led to an increase in the range of information available publicly and privately. The growing number of online venues in which suspicious information can be exchanged, along with the move to remote and hybrid work models, makes it more challenging for regulators and compliance teams to keep up. These trends mean it is more critical than ever for firms to employ state-of-the-art surveillance technology and procedures, customised to the way they do business.
Regulators such as the FCA have acknowledged that some traditional trade surveillance methods may be less successful in an environment of continued market-moving news. They have also emphasised that firms have a collective responsibility to ensure integrity in the financial system – and in their own institutions – is not shaken.
The FCA’s executive director of enforcement and market oversight, Mark Steward, has highlighted that insider dealing – and other stock market manipulation pursuits – are vitally important to the FCA and remain of significant enforcement interest to the regulator.
Regulators have also issued fresh guidance on market abuse and insider dealing, encouraging buy-and sell-side firms to recognise their responsibilities and elevate their compliance protocols. This includes ensuring firms are conducting mandatory staff training and working on instilling a stronger culture of ethics and responsibility.
It is vital for firms to update and adapt their risk frameworks, assessments and controls based on this new environment. This includes employing trade surveillance tools focused on ferreting out insider dealing in addition to surveilling lines of communication, establishing responsibilities for the three lines of defence and placing overall controls over that surveillance. The aim is to ensure firms are not only monitoring for insider dealing activity but reporting on it as well.
Above all, firms are being encouraged to update their legacy surveillance technology to remain agile and adapt to the changing face of insider dealing, among other evolving challenges.
Effective surveillance technology relies on spotting anomalies and changing patterns in data and behaviour. Traditional legacy systems are no longer fit for this purpose, particularly during times of market stress where they are generating additional suspicious transaction and order reports, and adding to the noise, making it harder for compliance professionals to identify the true problem areas.
Companies focused on heading off issues and meeting new standards are increasing the sophistication and range of surveillance tools used, including effective use of automation to take a more intelligent approach. Next-generation systems are better powered to extract the signal from the noise as the amount and types of data continue growing. Trade surveillance software powered by robotic process automation, in conjunction with machine learning, is better equipped to escalate the most actionable alerts, avoiding time-wasting chases.
Also providing an edge in the surveillance realm is new tech functionality, such as developing and testing trader profiles to help firms better monitor unique trading patterns and histories, and detect anomalies over time. Some firms are also looking for enhanced digital asset transaction monitoring, and improved speed and throughput for processes, for a truly efficient and auditable surveillance programme.
Insider dealing has been around for as long as financial markets have. While the law tries to keep up, the temptation for personal profit will lead to newer and more creative methods of circumventing it. Regulators have made clear that firms will need to act soon to ensure their surveillance programmes are comprehensive and able to meet the challenges of today and tomorrow if they are to avoid regulatory fines and reputational damage if anyone trading on their watch is found to be evading the law.
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Eventus Systems is a leading global provider of multi-asset class trade surveillance and market risk solutions. Its powerful, award-winning Validus platform is easy to deploy, customize and operate across equities, options, futures, foreign exchange (FX), fixed income and digital asset markets. Validus is proven in the most complex, high-volume and real-time environments of tier-1 banks, broker-dealers, futures commission merchants (FCMs), proprietary trading groups, market centers, buy-side institutions, energy and commodity trading firms, and regulators. The company’s rapidly growing client base relies on Validus and Eventus’ responsive support and product development teams to overcome its most pressing regulatory challenges. For more, visit www.eventus.com.