Market surveillance systems for FICC desks
This article first appeared in TabbFORUM, 8th November 2016.
Most institutions are not 100% ready for the new set of rules under the Market Abuse Regulation (MAR). Although most sell-side firms have some form of market surveillance in place, there is significant work outstanding to comply with MAR as some of the finer details were glanced over, in order to meet the deadline. It is worth noting that the biggest gaps remain in FICC (Fixed Income, Currencies and Commodities). It has been just over one year since the Bank of England has published its Fair and Effective Markets Review addressing misconduct and market manipulation in FICC markets with participants being accused of ‘ethical drift’; a disappointing observation though not entirely surprising given the complexity of surveillance in FICC markets.
The EU’s MiFID II and MAR regulations will require firms to extend market surveillance capabilities to fixed income, currencies and commodities, as well as capture market manipulation intent by reporting suspicious orders as well as suspicious transactions. Whilst most firms have systems in place providing coverage of electronic equities trading (as a result of complying with the older Market Abuse Directive or ‘MAD’ rules), asset classes such as fixed income, currencies and commodities require a different treatment altogether due to their different characteristics. Are firms fully confident that their system will report all potential intent scenarios in an RFQ world, or correctly mark commodity-specific instruments such as hour-ahead electricity contracts without risking “marking the close” at the end of each hour?
Organisations trading in FICC markets need to ensure that the full spectrum of market manipulation cases is covered for their specific ways of trading covering detection of market abuse intent and cross instrument alert scenarios. Automated market surveillance systems specifically designed to cover the FICC markets can help plug the gaps, notably in the areas of alert logic, calibration and case management.
- Alert logic: Older surveillance systems fall short in applying the relevant alert logic for FICC markets, for example, correctly representing and reconstructing RFQ (Request for Quote) or OTC (Over The Counter) sessions. Firms simply applying CLOB (Central Limit Order Book) equities trading alert logic to FICC trading will not work as all alert logic needs to be reviewed and transposed to the specific market structure and instrument types used in FICC markets. RFQ and OTC types of transactions lead to different types of abuse that are commonly seen when using CLOB. The different liquidity and correlation between FICC instruments needs to be considered as well.
- Alert calibration: It is a regulatory requirement for firms to rigorously review parameters for their alerts, and provide the rationale to regulators as to why these specific parameters have been selected, as well as the careful recording of any changes along the way in an immutable audit trail.
A market surveillance system should enable you to specify a number of parameters for each alert instance, based on, for example, the timeframe of an evaluation window. Whilst vendors can suggest certain parameters or approaches, firms ultimately need to calibrate alerts based on their own specific business and instruments traded. For example, it could be considered useful to set up a parameter for a minimum profit on a spoofing alert in order to avoid pursuing alerts for profits of nominal amounts. Following on from the same example in an algorithmic trading setup, frequent but relatively low profits on nominal amounts by a certain trader, client or algorithm may, on the other hand, require a closer look on suspiciously-timed small but accumulating profits over a longer time horizon.
The various parameters can be configured with some firms, say, wanting to have different parameters set up for government bonds and corporate bonds, or liquid and illiquid bonds using alert instances. In addition to the above described “production” alerts, forensic alerts can also be created. Focusing on a specific client, trader or algorithm which might have shown some unusual behaviour and needs to be subjected to higher levels of scrutiny. Alerts can be setup to provide reports focussing on specific traders so that a STOR can be submitted with confidence.
- Case management: Once alerts are correctly calibrated with false positives (noise) and false negatives (blind spots) kept to a minimum, behavioural patterns can be more easily detected. Market surveillance platforms can make thematic reviews easier by allowing firms to build a case by grouping potentially related alerts, with the option of adding comments. This provides the ability to build a case picture or visualisation of events over an extended period of time, by either a trader, client or algorithm.
The surveillance platform considers these alerts as a stream of events that can either be assigned to cases or reviewed individually. By grouping alerts together, the process of investigating, documenting and/or attaching supporting files is elegantly streamlined. Because alerts can be grouped in multiple ways, individual alerts can also be involved in multiple cases. Compliance teams have the opportunity to share folders and view workflow either on an individual or team basis.
In dealing with the increased market surveillance requirements for FICC markets brought about by MiFID II (due to greater electronification of FICC markets, bringing more instruments under the Market Abuse Regulation), large firms in particular are rightly hesitant about a complete replacement of existing workflow processes. Whilst vendor solutions such as Ancoa generally provide a proprietary case management system, another option can be to plug a vendor solution into a firm’s existing general purpose case management system. This integration method can prove to be an effective way of facilitating a smooth deployment.
Whilst the buy-side and sell-side generally have more-than-adequate platforms for cash equities and listed options, there are still gaps in compliance with the MAR and MiFID II regulations when dealing with FICC markets, most specifically in the area of monitoring intent of potential market abuse. Some firms are perhaps considering building their own in-house bolt-on, though history has shown that this mistake is fraught with danger (as recent record-breaking regulatory fines have shown). Vendor market surveillance solutions that are specifically adapted for dealing with FICC markets provide peace of mind that all the gaps are indeed covered.