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There’s a recurrent nightmare shared by many compliance officers.

It involves as little as a single rogue trader secretly conspiring with peers at other firms over an encrypted channel like WhatsApp or ProtonMail to manipulate interest rates, or energy prices, or one of the many other trading markets.

Schemes like these can subject firms to enormous financial penalties and in some cases tear down the enterprise altogether. Because they often originate from a single point of weakness – an unscrupulous employee – they can also be very difficult to spot before they blow up.

How can executives protect their firms against the outsized harm market manipulation can inflict? That is the challenge we take up in this blog post.

The Problem

The Securities and Exchange Commission (SEC) reports that market manipulation enforcement actions comprised 7% of the cases it brought last fiscal year, down slightly from 9% in FY2017. That may seem like a relatively small percentage, but it’s not wholly surprising considering that market manipulation requires a degree of coordination and malice beyond that of simply trading on inside information or including misleading information in an offering document.

What tends to trouble compliance officers is not necessarily the volume of market manipulation schemes but, rather, their potentially large impact on a firm’s bottom line and their increasing variety and computer-aided sophistication. In its 2017 annual report, the SEC reflected on how technology has emboldened market manipulators and other wrongdoers:

Just a few years ago, it was difficult to imagine a market manipulation scheme accomplished by hacking into the electronic accounts of others and then forcing trades to pump up a stock price. Or the brokering of stolen inside information on the so-called “dark web,” paid for in untraceable cryptocurrency. Yet these are the sort of schemes we now frequently encounter.

Other schemes the SEC has pursued in the past two years include traders manipulating markets by spreading false information via social media, manipulating stock prices through false regulatory filings, and engaging in a variety of pump-and-dump schemes involving misleading press releases timed to coincide with long and short trades.

The Solutions

These challenges do not just bedevil the SEC — they also keep compliance officers up at night.  How can firms build a bulwark against this sort of misbehavior by a rogue employee?

Mandatory Leave

Forcing employees to take periodic breaks from work and their access to trading and account tools can both interrupt a market manipulation scheme and help to reveal it.

The thinking goes that a scheme requiring constant attention from the wrongdoing employee will falter if he is forced to take time away from it. An interruption in market manipulation tactics may also generate noticeable changes in trading activity that clue compliance offices in to the existence of the scheme.

Sometimes the only way to catch someone in the act is to utilize the element of surprise.

Still, compliance officers are right to worry that savvy, clever manipulators may plan their schemes around vacation time to avoid detection. That is why some firms consider taking it a step further and consider instituting a randomized and unannounced mandatory leave policy, such that rogue traders do not know when they might lose access to accounts and facilities necessary to keep their scheme running.  

This may seem drastic, but sometimes the only way to catch someone in the act is to utilize the element of surprise, much like unannounced regulatory examinations that regulators sometimes conduct when they receive a tip from a whistleblower.  Although this may put a damper on some trading strategies, it’s pennies on the dollar compared to the 7, 8, 9, or even 10-digit fine that your firm could incur from regulatory penalties from a regulatory fine from these types of violations.

Harness Big Data and RegTech

Market manipulation schemes rely, in part, on wrongdoers’ ability to hide tiny droplets of market-moving information within the torrent of trading data that firms generate and process daily. In yesteryear, these droplets could be well-nigh impossible to detect, but that is no longer the case. Today, a compliance team familiar with big data and equipped with the right tools with which to parse it can spot anomalies and red flags with surprising consistency.

Once a compliance team has clarity on its obligations, it can also equip itself with compliance solutions that screen data for anomalous activity.

Just what are the “right tools”? To start with, firms need to understand and stay on top of how regulations define permissible and impermissible trading behaviors. That is where solutions like Ascent’s natural language processing and AI come in handy by parsing regulatory text to help compliance teams define what their traders can and cannot do, and what their obligations as compliance officers are to monitor trading activity.

Once a compliance team has clarity on its obligations, it can also equip itself with compliance solutions that screen data for anomalous activity. As AI-powered data analysis becomes more sophisticated, these solutions can learn from your firm’s historical trading patterns to identify anything that seems out of the ordinary.

Enforce Strong Controls and Immediate Follow Up

One often fail-safe way to avoid the more common market manipulation schemes is simply to adopt controls around the types of markets your firm will trade in. The market in thinly-traded “penny” stocks, for instance, provides fertile ground for manipulative activity. Banning your employees from dipping their toe into that and similar markets can head problems off before they ever begin.

Think of the famous Michael Jordan quote of “you miss 100% of the shots you don’t take” — except in this instance, not “taking the shot” may just be your firm’s most effective control.

For all the sports fans reading this, think of the famous Michael Jordan quote of “you miss 100% of the shots you don’t take” – except in this instance, not “taking the shot” in certain risky markets may just be your firm’s most effective control on market manipulation, because your employees won’t even be able to dabble in that area.

A common but often overlooked control is impose a ban on the use of communications channels not monitored by the firm can close off the potential for secretive communications between co-conspirators.  Although it is difficult to outright prevent an employee from using outside communication mediums, imposing an official ban of these types of programs can often make an employee think twice before engaging in these types of activities, which would prevent an issue before it even starts.  

In the unfortunate occurrence that your compliance team does spot an anomaly, it is also critically important to follow up immediately. Here, again, there are many RegTech providers that can help by arming a compliance officer with AI-driven data about the firm’s, and even an individual employee’s, historical trading patterns and how particular trades deviated from the norm.

With this information in hand, compliance officers can assess whether a trader’s explanation of the logic behind a position sounds legitimate or suspicious. That same information can crucial reliable raw material for self-reporting suspicious activity to market regulators.

Share War Stories With Fellow Compliance Professionals

One reason the SEC publishes details about the schemes it uncovers is to alert market participants to emerging dangers. By the same token, compliance officers can harness the knowledge of their peers by attending industry conferences like ACAMS-sponsored events and sharing details of schemes they have uncovered or suspected.

Like it or not, compliance officers are in the business of private law enforcement. Just as information sharing among governmental investigative agencies helps uncover plots, so too can talking shop with a compliance executive at a peer firm help you protect against market manipulation by your own employees.

 

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Ascent helps customers automate and manage their compliance programs through a simple-to-use, cloud-based platform powered by Regulation AI. We help you reduce risk, control costs, and achieve total confidence in your compliance program.

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