In Market Watch 68 the Financial Conduct Authority (FCA) has returned to the subject of transaction reporting and suspicious transaction reporting and identified an area of concern in rates and fixed-interest markets relating to potential market manipulation surveillance gaps. These were referred to in Market Watch 48, 50 and 56. The gaps are occurring regarding order activity messaging by clients/users on inter-dealer broker (IDB) platforms that allow users, during various types of sessions, to electronically place, amend or cancel orders.
Inter-dealer brokers may offer mid-price-based matching sessions (discussed here), either throughout the entire trading day (continuous sessions), at predefined times (periodic sessions), or ad-hoc (pop-up sessions) at the discretion of the broker.
In Market Watch 68 the FCA said that, for some rates and fixed-income products, these platforms supplement traditional services in a hybrid broking model, working alongside central limit order book style platforms, within an organised trading facility or multilateral trading facility. In some cases, it said, electronic execution platforms require formal connection and interface with a user’s trading systems, which means that order and trade messages are systematically recorded. Some platforms’ connectivity is made via web-based user interfaces, however, where direct connection to users’ trading systems is not required and users have been unable to establish one, the FCA said.
Background to hybrid broking models
In a fintech report, the International Organisation of Securities Commissions (IOSCO) said that regulations following the 2008 financial crisis (liquidity requirements, capital charges, etc.,) forced broker dealers to decrease the amount of balance sheet committed to holding positions to facilitate execution. This prevented them from making markets in the broadest sense possible, and electronic trading platforms had attempted to step in, IOSCO said. The first generation of electronic trading of corporate bonds, it said, was largely a request for quote (RFQ) process in electronic form, which added efficiencies in price discovery and permitted greater automation of recordkeeping and trade processing.
It said also that there had been a significant increase in the number of electronic trading venues and a variety of alternative protocols, including order books with live and executable orders, session based-trading and platform-determined midpoint pricing. Furthermore, it said, platforms and technology providers were increasingly focusing on identifying and matching firm orders (rather than quotes) and connecting all market participants (including the buy side).
Hybrid voice and electronic broking
As discussed here in relation to the U.S. Treasuries market, in the early days of electronic trading the voice and electronic broking businesses of the IDBs were run separately. Since then, IDBs have combined the two, creating hybrid voice and electronic broking operations whereby orders and trades coming in over the phone are combined with those being submitted electronically into a larger liquidity pool that is distributed over screens and software.
The FCA is highlighting findings regarding the surveillance of order activity on such platforms which could be used to engage in market manipulation, such as spoofing and layering (discussed here and here). Under art 16(2) of UK MAR, platform users have obligations to conduct market abuse surveillance. This includes monitoring all their orders and transactions.
The FCA is seeking to remind compliance departments within firms which use such platforms that they must be aware of their use, and that the order data must always be captured for market abuse surveillance purposes. Otherwise, it said, users may fail to identify potential market abuse (including attempted market abuse) — particularly those forms of market manipulation which involve placing orders that traders intend, subsequently, to cancel.
Article 16(2) also provides that market operators and investment firms which operate a trading venue shall establish and maintain effective arrangements, systems and procedures aimed at preventing and detecting insider dealing, market manipulation and attempted insider dealing and market manipulation. The regulation mandates the reporting of orders and transactions, including any cancellations or modifications that could constitute insider dealing, market manipulation or attempted insider dealing or market manipulation.
It also provides that any person professionally arranging or executing transactions shall establish and maintain effective arrangements, systems and procedures to detect and report suspicious orders and transactions. Where such a person has a reasonable suspicion that an order or transaction in any financial instrument, whether placed or executed on or outside a trading venue, could constitute insider dealing, market manipulation or attempted insider dealing or market manipulation, the person shall notify the competent authority.
The issue raised by the FCA is that ─ while details for trades executed on web-based platforms are generally recorded in users’ trade booking systems ─ users do not always systematically record the related order messages that precede execution, and those orders which do not result in a trade (including cancellations and amendments). As noted by the FCA, orders are a critical component in effective monitoring for some types of actual or attempted market manipulation — such as in layering and spoofing as well as cross-venue and product manipulation, where users have a unique line of sight of their own trader activity. If firms do not capture all unexecuted orders, the FCA said, they might fail to identify that activity.
The FCA said it has observed that users of web-based platforms find “initial challenges in getting usable data in a format suitable for surveillance”, and that this remains a significant gap in many users’ market abuse surveillance. The regulator has also noted that some firms’ risk assessments do not include business entered on web-based platforms, particularly orders which are deleted or otherwise do not result in a trade. Such an issue was considered in an unsuccessful unfair dismissal action, Mr K Y Choo v Citigroup Global Markets Ltd (Citi) (cited in Market Watch 67).
The case concerned alleged spoofing involving altered bids by Choo, a trader on the Emerging Markets Credit Trading desk. Choo was trading in Sloveni
an government bonds on the Euro MTS platform. Employment Judge Gardner noted that Citi had not had real-time data as to when Choo had adjusted the bid and offer prices, and to what extent that was information held by the MTS, the third-party platform provider, and was therefore not available to Citi until it was communicated by the FCA. Employment Judge Gardner said that all financial trading in the UK was regulated by the FCA, but that the FCA relied to a large extent on financial institutions conducting their own surveillance and reporting any suspicious trading activity.
He also said that all market participants had an obligation under the Market Abuse Regulations to report any suspected market abuse to the relevant financial regulator, and that a report of suspicious activity was known as a suspicious transaction and order report (STOR). Notwithstanding these remarks, the obligation on firms to engage in suspicious transactions reporting was not an issue in the case.
Recordkeeping requirements and onboarding
In Market Watch 68 the FCA also said that, in addition to failing to meet the requirements under art 16(2) of UK MAR, firms may also be falling short of their obligations under art 25(1) of UK MiFIR, which requires them to keep data relating to all orders and transactions for five years. The FCA is pointing out that ─ in addition to the possible failure of a firm to monitor manipulative activity and report its own suspicions, if any, to the FCA ─ it may also be preventing the FCA from monitoring the market using such data, and might also be unable to respond satisfactorily to regulatory enquiries from the FCA.
The FCA also said that firms with formal procedures and good governance for onboarding new platforms were better able to ensure they captured and monitored all relevant trade and order data. It said those that made the ability to retrieve such data a prerequisite to onboarding platforms reduced the risk that they would fail to meet regulatory obligations. The consideration of their ability to meet their market abuse surveillance obligations should inform their choice of platform, the FCA said.
It also said, as discussed in Market Watch 56, that it continued to observe firms using questionable rationales to justify their potential failure to meet their obligations under UK MAR ─ such as a perception that some of their peers were failing in the same way ─ which was unacceptable. It also said that the absence of a specific enforcement action having been taken with regard to a particular regulatory failure did not mean that such an action would not be taken in the future. The FCA said it had decided on enforcement action on the basis of a number of factors, and that many of those factors would vary between firms — even apparently similar firms within the same industry peer group.
Surveillance obligations of trading venue
The FCA also reminded operators of trading venues of their obligations to undertake effective monitoring to prevent, identify and report potential market abuse. It said they should consider how they could help users to meet their own regulatory obligations for orders and transactions by providing them with data in a usable format. In addition, trading venue operators were also reminded of their obligations to maintain order data according to the standards and formats prescribed in Annex I of the UK version of Regulation 580/2017, pursuant to art 25(1) of UK MiFIR, and that they are required to supply such data when the FCA requests it.
In the market abuse enforcement case case of FCA v Paul Axel Walter the FCA imposed a financial penalty of £60,090 on Walter, a former Bank of America Merrill Lynch International bond trader. Walter was found to have engaged in market abuse by creating a false and misleading impression as to supply and demand in the market for Dutch State Loans (DSL) on 12 occasions in July and August 2014.
Specifically, the FCA found that, on 11 occasions, Walter had entered a series of quotes that became the best bids on BrokerTec, an electronic inter-dealer trading platform, giving the impression that he was a buyer in a DSL. Other market participants who were tracking his quotes with algorithms followed him in response and raised their bids. Walter then sold to those other participants and cancelled his own quote.
Despite placing quotes that suggested he wanted to buy, he sold the DSL. On one further occasion, Walter did the opposite by attracting market participants to follow him, with the result that he purchased the DSL from the market participants who had recently lowered their offer price, and then cancelled his own quote.
The platform was alerted to the matter when it received a complaint from a market participant. BrokerTec had also raised the matter in a telephone call with Walter. The suspicious transaction reporting obligations of the platform operator were not, however, an issue in the case.
Further information on compliance matters can be found https://podcasts.apple.com/gb/podcast/compliance-clarified-podcast-by-thomson-reuters-regulatory/id1548510826 here.