FCA reveals common weaknesses in market abuse surveillance
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The UK Financial Conduct Authority (FCA) has identified a number of common weaknesses in market abuse surveillance arrangements at small and medium sized firms. This briefing considers these and the action firms can take to ensure their own systems are fit for purpose.
Firms are required to identify and report instances of potential market abuse and must have effective arrangements in place to detect and report suspicious activity. The FCA recently published Market Watch 69, in which it shares its observations from a review of small and medium sized firms’ arrangements for market abuse surveillance.
Market abuse risk assessments
Comprehensive, accurate and up-to-date market abuse risk assessments help to ensure effective surveillance coverage.
While the FCA observed that some firms have been using market abuse risk assessments effectively, there were a number of weaknesses that firms tended to repeat.
For example, consideration of market abuse at a high level and as a single risk, rather than considering the different types of market abuse (eg layering, spoofing, wash trading, ramping); and how different levels of risk might apply to different types of business activity (eg discretionary vs execution-only) and asset classes.
Weaker risk assessments failed to consider method of execution (eg electronic vs voice-brokered markets) or the nature of the platform where trading takes place (eg lit vs dark books).
The FCA expects firms to consider different types of market abuse, the different areas of business in which they operate, how that business is undertaken, and the different asset classes and instruments traded. Failure to do so risks a firm being unable to adequately identify market abuse risks and align its monitoring programme to them to ensure effective surveillance.
Order and Trade Surveillance
When it comes to order and trade surveillance, good systems will have the following:
- Appropriately calibrated alert scenarios that consider the different characteristics of different asset classes and instruments. Using a common threshold for all instruments risks ineffectively monitoring (because the threshold is too high or too low), or generating a high level of unnecessary ‘noise’ through picking up a large number of false positives.
- Appropriate thresholds applied to calibration. For example, appropriate lookback periods for insider dealing, which consider the time that inside information might exist before it is released.
- Monitoring of all orders and trades. For example, monitoring of cancelled and amended orders is critical to identifying certain forms of market manipulation.
- Thorough review of surveillance exception alerts. Some firms are only escalating reports where there is an obvious link between the client and issuer or source of inside information. The absence of such a link is not a default rationale for closing alerts.
Policies and procedures
The FCA observed weaknesses where firms’ policies and procedures were vague, or lacked detail. For example, directing analysts to review surveillance reports for signs of market abuse, but not including guidance on what the signs might be. In such cases, it was common for alert reviews to be insufficient or incorrect, and for alerts to be inappropriately closed rather than escalated.
It is important to ensure that policies and procedures are clear, detailed and up-to-date. Additionally, policies and procedures should contain clear and practical guidance regarding what constitutes market abuse, how to recognise it, and how to review and escalate alerts.
Some firms were found to have outsourced aspects of their surveillance to another part of their organisation, or to separate organisations. Common weaknesses arose in outsourcing where there was limited understanding or oversight of the surveillance taking place. This included inadequate knowledge of alert logic and calibration, and weak quality assurance practices.
At some multinational firms, surveillance was being undertaken at a group level, but the local UK compliance teams had negligible understanding of the surveillance being carried out. In those cases, the surveillance was often ineffective for the UK business.
In order to avoid these pitfalls, oversight and governance are critical. Where there is delegation of market abuse surveillance to a separate organisation, the person delegating should have sufficient expertise and resources to properly oversee the services provided.
Assigning responsibility for market abuse surveillance to both the front office and an independent Compliance function, which perform monitoring separately from the business, can be an effective way to ensure surveillance is undertaken free from conflicts of interest.
The FCA accepts that smaller firms may require staff to perform dual roles in the front office and as part of Compliance. Where this is the case, the firm should consider whether it has adequately assessed any potential conflicts of interest and taken steps to mitigate them. Effective, tailored, market abuse training and escalation procedures are also a good idea.
Why take action?
The level of FCA enforcement action for market abuse remains relatively low, despite market abuse investigations occupying around 14% of the FCA’s investigations portfolio. However, delivering assertive action on market abuse forms part of the FCA's latest business plan focus on “reducing and preventing serious harm”. A core component of this plan is ensuring that firms have robust systems and controls, high quality reporting practices and a strong anti-market abuse culture.
Firms should review their systems and controls to ensure weaknesses, such as those highlighted in this article, are addressed to avoid becoming subject to unnecessary regulatory scrutiny.