European Broker Dealers: Using Technology to Tackle Bad Trades
As European financial firms embrace high frequency and algorithmic trading they are faced with another challenge: how to monitor for potential market manipulation amidst new guidelines set up by the European Securities and Markets Authority and greater regulatory oversight.
One quick answer: spend more on new software. Research firm Tabb Group, for one, predicts European broker-dealers will fork over upwards of E124 million in 2014 -- mainly on third party platforms. “Legacy systems are ill-equipped to monitor cross-border activity in real-time as market fragmentation, larger trading volumes and correlated trading takes place," says Tabb's senior analyst Rebecca Healey in London.
A cottage industry of software firms has emerged eager to capitalize on current inefficiencies. Based on their recent flurry of announcements, there are plenty of pickings. Market surveillance software firm Redkite Financial says it has teamed up with consultancy Kinetic Partners to offer a combined technology and operational evaluations package while technology giant SunGard says it has upgraded its Protegent Market Abuse software to accommodate the ESMA's guidelines. Progress Apama, a specialist in analyzing streaming data, and NICE Actimize, best known for financial crime risk and compliance software, have made similar claims.
The ESMA wants European broker-dealers to install a governance process for developing or buying algorithms; roll out their use in a cautious fashion; and ensure that their staff has the necessary expertise to monitor the behavior of the algorithm. The ESMA also wants firms to monitor their smart order routers, direct market access and high frequency orders to detect manipulative trading practices. Compliance officers will be responsible for ensuring that trading systems and algorithms meet the requirements. Also briefly cited among the new guidelines are requirements for managing risk on a pre-trade basis.
"The ESMA's guidance is a wakeup call for broker-dealers," says Trevor Barritt, head of compliance for NICE Actimize in Europe. "Globalization, high frequency and algorithmic trading didn't take place a few years ago so the task of monitoring trades was a lot more simple. That's no longer the case and broker-dealers must rise to the occasion."
The ESMA's guidelines aren't the only regulatory mandate broker-dealers have to worry about. They really just clarify what national securities watchdogs have been saying all along -- that unacceptable trading behavior must be monitored and reported to regulators as suspicious. Those regulators are just cracking the whip a bit more these days. The U.K.'s Financial Services Authority, which has won 14 criminal convictions for bad trading conduct since 2009, recently sent out letters to about 190 firms in the City of London questioning why they hadn't filed any suspicious activity reports or SARs. The FSA's market monitoring department now plans to spot check how well firms are reporting suspicious trades as part of a broader crackdown on market abuse. At least a dozen on-site visits are planned.
Exchanges are also making delinquent broker-dealers pay up for their ill-preparedness. Case in point: Morgan Stanley was just fined 400,000 Swedish Kroner by Nasdaq OMX for an algo trading error. In late November, says Nasdaq OMX, a coding glitch caused Morgan Stanley accidentally to submit a large number of erroneous orders where the buyer and seller were the same person. Nasdaq OMX did catch the error, but couldn't reach a trader at Morgan Stanley in time. The brokerage firm, it claims, did not have the necessary technical and administrative skills to oversee algo trading.
"Firms need to have the correct automated tools in place to monitor their trades for illegal and suspicious activity on a near-real time basis," says Monique Melis, partner and head of the regulatory consulting practice for Kinetic Partners in London. "They can no longer rely on Excel spreadsheets which could easily miss bad trades."
Relying on even the most sophisticated front-end systems won't cut it. "Front end order management and execution management systems have some monitoring features but they are not geared toward monitoring abusive trade patterns," says Justin Amos, co-founder and chief operating officer for Redkite in London. "Financial firms have instead depended on checking a sample of their trades periodically but that approach is no longer what is being asked for."
The reason: sampling doesn't allow firms to compare data on the size of the trade and price executed with historic and current market data and news factors which can indicate insider or manipulative trading activities. "There is a flood of data that must be evaluated in microseconds for suspicious trading patterns and risk management both after and before the trade occurs," says Richard Bentley, vice president of capital markets solutions for Progress Apama in London. "A snapshot of data in time won't do that." The microsecond timetable is particularly relevant for pre-trade intervention when checks have to be done without adding latency to orders.
Software vendors involved in market surveillance are making similar claims on upgrades to their platforms so picking the best one isn't that easy. Bentley says Progress Apama's platform will monitor electronic trading patterns in real time; issue prioritized alerts; and block or cancel unauthorized trades or trades outside pre-set requirements. Redkite's platform, says Amos, analyzes order level data and the price at which the trade was executive relative to other activity with streaming real-time and historic pricing data, trade patterns and real-time news events.
"NICE Actimize upgraded its market surveillance software in order to ensure full coverage of ESMA's guidelines, in accordance with its policy of ensuring full regulatory compliance. We looked at the four scenarios cited by the ESMA has having a high incidence and matched them to pre-existing scenarios we programmed and added one more," explains Barritt. Russian brokerage Otkritie Capital, for one, has just signed up with NICE Actimize to monitor money laundering and trading activities.
SunGard's Protegent Market Abuse software has also expanded its rules-based library to allow compliance officers to be alerted in the event of a violation of ESMA's guidelines prohibiting illegal transactions. "The new updated version will take in details of orders, market data and executed transactions which back-office systems now used to track down illegal trades would be unable to incorporate," says Magnus Almqvist, product manager for Protegent in London.
As is often the case with regulatory mandates, technology alone isn't a solution. It simply provides compliance officers with a better monitoring tool. Compliance and trading departments which might have previously enjoyed either an adversarial or lukewarm relationship at best had better cozy up -- and quickly unless or find themselves on the receiving end of some pretty hefty financial penalties and reputational risk. “Compliance executives will need to quickly understand a lot more about trading strategies while traders will be put on alert that compliance departments are armed with electronic tools to keep track of their activities in real-time," says Almqvist.
The fear of running foul of regulatory guidelines for market surveillance could also prompt financial firms to dedicate trade monitoring experts within their compliance department or at the very least add more compliance officers. "Tier One brokers may already have full time specialist trade monitoring experts in their compliance departments, while smaller to mid-tier firms likely have part-time staff," says Almqvist.
With specialization will come the need to understand just how any software used actually works. Kinetic Partners is providing compliance executives with some training in market surveillance and interpreting any alerts -- or red flags -- in trading highlighted by Redkite's platform. NICE Actimize's Barritt recommends that financial firms consider the ease of understanding alerts as a factor in selecting a market surveillance tool. "They need to do an internal test run to ensure it doesn't generate too many false positives and it provides a clear written explanation of the reason the trade was flagged as suspicious." Compliance executives don't need a lot of meaningless undecipherable data on their hands.
Naturally, financial firms will also need to ensure that they have documented procedures for how they will investigate any potential alerts, notify senior management and even regulators if necessary. Taking a more proactive approach could help reduce if not eliminate regulatory fines and reputational risk. "Compliance departments, not trading desks, need to take charge of the trade monitoring process to avoid any conflicts of interest or errors," says Almqvist.
Written by Chris Kentouris, Editor in chief (Chris can be contacted through Chris.Kentouris@hotmail.com)