Thoughts on the FSA Business Plan

For anyone who believes that securities markets should be fair there is much to like in the FSA's new business plan (albeit one has to read between the lines somewhat).

If markets are abused because of greed the extent of the abuse is tempered only by fear of detection and punishment. The FSA's new philosophy of "credible deterrence" must therefore be good news, so long as it is effective in practice. The shift from a "principles based" approach (for which read the much criticised light-touch regime) to an "outcomes focused" one, coupled with a willingness to be more confrontional, is encouraging, as is the recognition that this will need better people, systems and analytical techniques.

However, when the FSA talks about market abuse they focus on insider dealing, and in their plan the other classes of market abuse - which are at least as significant a problem - are further de-emphasised. Reducing insider dealing is clearly a good thing, but it is not enough.

Deterring the other forms of abuse is harder. As we at AVENUES have often observed (most recently in a press briefing on 16 March 2010) this difficulty is exacerbated by an unintended consequence of MiFID, in that with fragmented markets abuse is easier to disguise. No single pair of eyes can oversee the activity across all trading venues with sufficient completeness and accuracy.

So the FSA is right to plan to press for a review of MiFID, seeking enhanced transparency and improved consolidation of post-trade data. This is a step in the right direction (but one that must be taken with one leg tied to the EU).

The plan represents several necessary steps, but not the whole journey towards fair markets.

The Economics Of Market Surveillance

In today’s world, before one can address the regulatory or moral issues of surveillance, it is realistic to suggest that one has to address the economics for surveillance.

Market venues find themselves in a highly competitive cut throat price war where there is a race to the bottom on trading tariffs. Therefore all their attention is on developing or retaining the secondary trading business and current strategies are threefold:

• cut costs and develop other complementary businesses e.g. clearing and settlement, data centre services, market data or whatever;

• develop economies of scale in the core trading business by attracting or acquiring liquidity as a direct benefit of cost cutting, innovation in the underlying trading services and / or acquiring competing venues (the latest examples being Nyfix Euromillennium in the case of NYSE Euronext, Turquoise in the case of the LSE, preceded by a number in North America to prevent the demise of NASDAQ and NYSE); and

• minimise the expenditure on fringe activities - and currently for venues, surveillance increasingly falls into this category.

Cutting costs per se may be a necessary short term solution particularly for non-performing functions. However, it is not a long term success factor as the net result on earnings for a venue may be nil as it is likely that cost cutting will be matched by tariff reductions. This is particularly true of the fight to attract or retain new liquidity in the form of high frequency trading (HFT) – HFT has little venue loyalty, not even as long as it takes to do a double click. Cost cutting is essential for incumbent markets as they are expensive compared to new entrants. In the case of NYSE Euronext in Europe it is estimated that each trade costs an extra 4.5 basis points compared to an optimal best execution price discovery venues for the most liquid European securities (based on Equiduct data in Sept 09). Other venues have different levels of in built inefficiencies – both higher and lower.

For longer term success, markets need to compete on market quality, providing higher levels of market surveillance with a greater probability of market abuse detection. If markets compete on market quality, in the long term this is likely to attract buy side interest as they can choose where they direct their order flow. Many buy side organisations today in Europe believe they do not consistently receive best execution, but they cannot prove it. They also cannot prove whether their order flow is manipulated by market abuse activity, though many suspect it is.

The challenge, however, is how can venues compete on market quality and implement modern surveillance solutions without substantially increasing their expenditure? If the regulators or the venues do not want to compete on market quality, then the buy side need to organise themselves to demand market quality metrics for each trade and the content of order books.

All things being equal - and after a race to the bottom on tariffs and latency - they will indeed tend to be equal among the surviving venues, what is left to compete on other than the integrity of the venues? Why would a buy-side player direct his business to a venue that could not demonstrate its integrity compared to one that can. So the question venues who want to thrive ought to be asking is not how little can I get away with spending on surveillance, to satisfy my regulator, but how can I arrange that surveillance is done to the best possible standard in the most cost-effective way?

In future blogs we will discuss the ideas we in the AVENUES Alliance have been developing to answer this question.

The Need for Multi-Market Surveillance

Market surveillance functions within regulators and some trading venues are required to monitor market activity and behaviour in order to protect and develop market quality by identifying market abuse and financial crime. In so doing, the market surveillance function in theory provides a level of investor protection and ensures that investors receive a fair price on any investment decisions, achieved through an objective price discovery process.

In this new decade, the key questions are:
1. Is price discovery still objective, given the very high proportion of algorithmic and automated trading and if it isn’t totally objective, what are the implications for investor protection and market surveillance?; and
2. Do existing market surveillance methodologies protect investors and root out market abuse in the context of modern market structures?

At Avenues, we believe that market structures have changed so significantly in the last couple of years, particularly in Europe and North America, to call into question how effective is surveillance of the markets as a whole. Now securities markets are highly fragmented and globally interconnected, with trading in the liquid securities being scattered across five, ten or more public and private trading venues (as well as multiple asset classes), with various categories of market, light, dark, OTC and hybrids. Individual market surveillance functions however can only see their own traffic (a subset of the overall market), and on certain case by case bases, can request data from other co-operating venues or jurisdictions, where they observe abnormal behaviour from their own data sets.

At Avenues we believe this traditional approach of each venue seeing only its own traffic does not fully benefit total market quality and investor protection. Different parties are responsible for different areas of market quality – with no-one seeing the total picture in real time or even near real time. In Europe, best execution enforcement is the role of the investment firm, while market surveillance is the responsibility of some venues, and risk management and market surveillance (using transaction report data) is the responsibility of regulators. If that is not sufficiently complicated and fragmented, in Europe in particular the regulatory standards that govern trading venues are not uniformly defined let alone the level of enforcement, creating an unlevel playing field between exchanges and MTFs on the one hand, and public and private marketplaces on the other. Collectively, these issues lay the gates open for market abuse activity to remain undetected. Even regulators do not have access to all data and furthermore they do not have the tools to optimise the chance of detecting market abuse. So there is no single set of eyes monitoring market activity and therefore no-one can confidently state that the markets are monitored and all abuse activity has been investigated.

How can we make such a statement? The answer is quite simple – one only needs to ask, what is the ratio of successfully convicted market abuse cases to trades?

The answer is no-one knows. This type of information is not in the public domain, but everyone knows it is infinitesimally small. While trade volumes in each of Europe, North America and Asia soar into their millions on a daily basis, the annual volume of successfully convicted market abuse cases remains below 5,000 globally (we estimate). It may be lower.

Does this mean that market abuse is not happening and all the regulations, systems, procedures and controls are operating effectively? It is tragic to think that the scale of global investment in surveillance infrastructure has such a low return. Yet sub-optimal investment decisions on best execution matters alone has such a high cost of leakage – in the UK alone, we estimated in 2008 that the cost of failure to implement best execution requirements accurately was between £400 and £600mn per annum, an outcome that is a direct result of some of the unplanned consequences of MiFID. What is the total opportunity cost of market abuse? – it must be enormous, especially when one considers that the first decade of the 21st century is the lost decade for pensions, at least in Europe.

If for one minute it is possible that there is market abuse and it is remaining undetected, the outcome from the current scenario is that every individual pension fund or investment is under-performing. Sadly, no individual service provider or investment firm is in a position to take a leadership position in the surveillance area, for fear of breaking the mould. Furthermore, those investment firms or venues that are driven by shareholder profits are neither willing nor required by regulators to invest further and improve the quality of surveillance, mainly because they cannot resolve the problem individually, due to the high level of fragmentation (in policy, responsibility, data and technology). Regulators also cannot afford to divert scarce taxpayer resources to such activities - especially following the recent crises - as their focus is on systemic risk management. Market abuse is not yet in the public eye. There has been no scandal – yet.

Market quality and investor protection are critical success factors of retaining and developing liquidity. Equally importantly, they are critical success factors in retaining the store of value in securities and the confidence in securities markets. If liquidity suffers, the share price or the earnings of the actual venue providing the market in turn suffers. If market abuse is proven to be rife, then economies will suffer. So how can markets improve the quality of market surveillance?

Avenues offers a fresh approach to this whole topic and have found a route through all the conflicting objectives to achieve solutions for the greater good at a lower cost. Our approach covers regulatory, business, strategic, operational and technical solutions. Avenues has the expertise and has designed a potentially leading solution using expertise of professionals involved in market surveillance over several years, and with access to technologies that run surveillance solutions in national security applications, processing astronomical volumes of disparate data with the view to protect our daily lives. Our collective skills and experience can offer the world and collective like minded groups the chance to use market surveillance as a real asset. We will explain more of our ideas on future blogs.

Joined-up thinking on fragmented markets

In a recent speech, Rick Ketchum, Chairman and CEO of FINRA, the US securities regulator makes many observations on "the lessons of regulatory failure". What caught my eye particularly was his call for regulators to have "a single set of eyes looking at the market holistically", announcing a "first step by consolidating the surveillance for insider trading".

I have been expecting an announcement like this for some time, and I doubt I am alone in that expectation. However I had expected it to come from Europe, where the problems of fragmented markets that Ketchum addressed are exacerbated by several other structural and political issues. Europe's fragmentation is not just of the markets, but also of the responsibility for surveillance of the markets.

Within the European Union, national regulators cooperate through CESR, the independent Committee of European Securities Regulators. National regulators, such as the UK's Financial Services Authority, monitor exchanges and trading venues within their jurisdiction, receiving trade reports from them and in many cases real time order book feeds too. The venues themselves operate surveillance on the activity transacted on or passing through their systems.

And the compliance function of market participants has a role. As Hector Sants, CEO of the FSA, puts it, "it is incumbent on the senior management of firms to guard against the risk that their staff will commit, or facilitate, market abuse". Quis custodiet ipsos custodes? Or in English, something about poachers and gamekeepers.

So, plenty of different people are striving to police market abuse. But how effectively? It is commonly believed that market abuse is rife. Investment managers will complain, for instance, that brokers forever front run large orders, but they can never prove it. And why should they prove it? All these regulators, surveillance departments and compliance functions should be detecting it and proving it. So either there is no market abuse, or it is not being detected, or it is being detected but deterrents are ineffective.

Let's suppose there is market abuse (otherwise why have regulators, surveillance or compliance trying to detect it - and anyway, we know there is abuse, and it is sometimes detected; just read the news). Let's further suppose that surveillance departments and regulators are on-the-ball and equipped with all the best available techniques and tools. Let's also suppose that someone wanting to abuse the market is not stupid or at least has some sense of self-preservation. Like any criminal they will make some trade off between gain, likelihood of detection and the pain of any consequent punishment. How likely are they to carry out an abuse in a way a single exchange's surveillance department could detect, or that a single national regulator should spot? Given our suppositions, this is not too likely.

So what does our market abuser do? Given Europe's market fragmentation, why wouldn't he spread his abusive activity over several venues, so that no "single set of eyes" can see it all? Each regulator, or surveillance department, is like the driver looking for his keys under the streetlamp, because that is where the light is, even though he may have lost them somewhere else. With this "fractured approach", as Ketchum rightly calls it, there are plenty of dark patches along the street for market abuses to be hidden.

If our abuser wants to front run our investment manager's large buy order in some stock that is traded on multiple venues, why wouldn't he spread his front running proprietary buys over several venues, then make the large customer buy on the primary market thereby increasing the stock's reference price, then spread the profitable disposal of his proprietary position over several venues. No one venue or regulator could see the front running episode holistically, reducing or removing the chance of its being detected.

Or why not buy call options on the stock, execute the large customer buy, increasing the reference price and hence the value of the options? Since options are often traded OTC the surveillance department or regulators may not see the options trades till much later, again reducing or removing the chance of the abuse being detected.

I don't want to put ideas in the market abuser's head, and I'm sure they can be more ingenious than this. And that's the real point: abusers have access to all these venues and instruments, they have high-speed, low-latency market access, they have sophisticated pricing and modelling algorithms, they have advanced tools for visualising markets and spotting opportunities. Don't the surveillance departments and regulators need the same? As Ketchum says, "one of the fundamental challenges facing any financial regulator is trying to keep pace with the dynamism and change that defines financial markets".

The abusers have greed and cunning (and much larger budgets than those who strive to catch them). Techniques for detecting abuse must keep ahead of the game. Again quoting Ketchum, rather than "fighting the last war ... the real test will be whether the regulatory system can evolve along with the financial system". This needs people able to use these advanced techniques and tools; Ketchum recognises the importance of "staff who bring a range of skills and experiences. In addition to fraud detection, they need to have forensic capabilities, knowledge of the technology used to facilitate securities manipulation and insider trading."

Ketchum, who "has spent most of (his) professional life working in market regulation" rather understates the case when he observes that "there are impediments to regulatory effectiveness that are not terribly well understood and potentially damaging to the integrity of the markets." I get the impression that he feels the impediments are many, daunting, and increasing. He touches, for instance, on "high frequency trading and dark pools".

But the longest journey starts with a single step. Techniques, tools and brilliant, creative and versatile people will not get far without information. Ketchum says, "information is inconsistent and incomplete - overwhelming in some contexts and non-existent in others ... at a minimum, all the data needs to be consolidated, with a single set of eyes looking at the market holistically. We've taken that first step by consolidating the surveillance for insider trading".

When will Europe acknowledge the need for that first step? Only then can it work out how to take it. And until it does Europe will lag the US, where Ketchum says, "there is much more to be done in the areas of front running, manipulation, abusive short selling, and just having a better understanding of who is moving the markets and why."

Ketchum quotes Thomas Jefferson as saying "the price of liberty is eternal vigilance." This is a misattribution (it seems to have been said first by Irishman John Philpot Curran). Which demonstrates that Americans have no monopoly on truths which are held to be self-evident.

The need for a consolidated view of all activity, information and transactions from every venue trading any given stock, and all and any related security, is self-evidently true in Europe too.

But that is not all that is needed. My colleagues in the AVENUES Alliance and I will continue to explore the needs and motives for real market surveillance so that one day the buy side - and so the rest of us through our investment and pension funds - receive best execution without interference by market abuse.