At the end of 2018, the UK Financial Conduct Authority published Market Watch 57 and 58 and called time on non-compliance with MAR and MiFID II. Radar asked industry experts to unravel what this means for firms, and what to expect next from the regulator.
In last four months of 2018, the UK Financial Conduct Authority (FCA) pumped out a flurry of Market Watch newsletters that attracted considerable interest from the surveillance community. Numbers 56, 57 and 58 work as a series to highlight and forewarn the market of regulatory requirements the regulator feels are being ignored. These include the surveillance of quotes and orders, as well as the practice of “flying” prices and “printing” trades.
With the Market Abuse Regulation (MAR) and MiFID II both bedding in over the last couple of years, FCA has been patient in its approach to non-compliance enforcement; it has given firms time to ask for clarity, produce timelines to resolution, and develop better technology. However, as Ruk Permal, forensic services partner at PricewaterhouseCoopers highlights, three years is long enough to become compliant. FCA is now at the point of acting on non-compliance it sniffs out.
“The regulator expectation is that, with all the communication and implementation plans and the time to establish granularity behind the specific parts of the regulation, it is time to comply with [MAR] as it is fully understood,” said Permal.
“Finger in the air” pricing
Market Watch 57 sets out FCA’s areas of concern surrounding “flying” and “printing”. “Flying” involves a firm communicating to their clients via screen, instant message, voice or other method, that it has bids or offers that are not actually supported by a trader’s instruction. “Printing” is communicating by one of the same methods that a trade has been executed at a specific price when it has not actually taken place.
For Tom Goodman, senior manager in Financial Crime Analytics at EY, it is apparent that these lesser-known practices have emerged from the broker market, where individuals are providing market participants with proactive pricing on an almost continuous basis, which “naturally puts them at greater risk”.
FCA suggests an appropriate response could be to make a clear distinction between a price which is supported by an order or a trader’s bid, and one which is indicative only. Goodman adds, “this is to some extent an extension of the overhaul of benchmark submission practices; from “finger in the air” figures liable to manipulation to robustly (trade and order) data supported information.”
However it is not clear whether this is now expected market practice, or just old fashioned good practice. In an attempt to decipher FCA’s direction, a senior head of monitoring commented that FCA’s suggested response could in fact upset the “delicate balance behind not revealing too much about the underlying order” adding that enforcement might only be possible where there is a “systematic, intentional and repeated pattern of baseless quoting”. Is this what FCA had in mind? Or are individual cases of “flying” and “printing” enough to warrant an enquiry from the regulator? If so, how are firms expected to detect each instance?
Market Watch 57 displays regulatory concern that firms are not currently using the appropriate oversight and surveillance systems to monitor chats and electronic communication. Instances of printing, flying and other illicit activity may therefore be going undetected.
“Firms should have appropriate oversight and systems and controls in place to ensure that the instructions which employees place on trading venues, or share via persistent chat systems […] do not give false or misleading impressions of the market.”
FCA wants to see these systems put in place, and in the event that instances of “flying” or “printing” are found, it expects firms to carry out an assessment and report its findings back to the regulator. While this approach sounds simple enough on paper, it will likely strike fear into the hearts of firms wondering how this can be put into practice and how they can employ a realistic, proportionate approach.
Goodman raised this as a “challenge”, which has been debated at some length by the industry. From a sell-side perspective, he observes two efforts of compliance with Market Watch 57. First, more staff training may raise awareness in the front office, and mitigate risk in the longer term. Second, some firms may then go a step further and undertake “a small amount of spot/sample checking through manual reconciliation of quotes given, as identified through comms surveillance, against trade and order data that may support these.”
Another fixed income compliance officer stated he feels FCA’s expectations are unrealistic. This level of monitoring could be particularly burdensome for firms if there is a requirement to monitor every time there’s an indication of interest (IOI) or axe in equities and fixed income. He agreed that a testing approach with “periodic sampling by first line or advisory” is more viable.
“We do not anticipate at this stage many, or perhaps any, firms will undertake an automated surveillance approach to this risk.”
Enforcing the unenforceable
If the first grey area surrounding Market Watch 57 is its practical application, the second is a doubt about the overall enforceability of FCA’s preferred approach. At a recent Behavox roundtable discussion, it was felt that enforcement could be a challenge for the regulator, especially given the lack of clarity regarding what is, and is not, an order. One attendee highlighted the complexities surrounding enforcement as “a very tough case for the regulator to bring unless there is a deliberate and continuous effort to mislead the client, which might only be identified by best ex checks.”
“The first enforcement case will not be the firm that has a systemic case of a regular stream of unsupported quotes, it will be the bank that does not respond to the regulator’s demands for a surveillance process behind this.”
Passing the blame
In Market Watch 58, the regulator’s patience appears to be running thin. This is especially true of quote surveillance; firms have had two years to develop, test and implement systems that will monitor illicit and fraudulent quotes. But with the pressures of Brexit on both resources and cash, is this a realistic expectation? And what can firms be doing to make sure they’re compliant?
The number of firms failing to comply with MAR’s guidance around quote surveillance is potentially more than FCA’s wording would imply, Ruk believes. “I’d be surprised if there were many, if any, that are able to do quote surveillance at this stage,” he said. Attendees of another recent roundtable backed this view.
It would be unfair to solely blame the businesses for their lack of compliance when the general consensus is that FCA haven’t given enough information about what it is they’re expecting to see. One Behavox community member perhaps spoke for many firms when they said “I don’t think [FCA] know what to do themselves about issues in developments around automated trading, encryption, social media and AI – so they push the burden to the firms. And the same can be said about quote surveillance.” Permal echoed this sentiment and added, while the implementation of the systems is challenging, this is made worse by lack of clarity around the interpretation of the data that it could produce.
“When is a quote a quote? When does a quote translate to an order? How many of those orders become an executed transaction? And how do you piece all that together?”
Getting creative with compliance
Market Watch 58 focuses primarily on compliance and obligations under MAR, as well as a reminder about STORs, insider lists and market soundings. Effective compliance with MAR, it says, requires “strong judgment” and a confidence from firms that their systems are detecting abusive behaviour. It goes on to say, “the list of manipulative behaviour indicators […] is neither exhaustive nor determinative”. With this in mind, some might wonder how they can be confident that abusive behaviour is on their radar, when the methods of such behaviour are potentially boundless.
EY’s Goodman said the absence of a prescriptive list of malpractice requires firms to get creative with their approach. “Some firms take a very narrow view that the list of risks that they “must” control are those defined in MAR text, or that the scenarios it looks for are defined by those offered through an off-the-shelf product,” he said. However, firms with a more mature approach to compliance recognise that the risk assessment is a living document and undertake a level of horizon-scanning detailed enough to amend the risk assessment as and when new risks are identified.
FCA’s expectation that firms capture behaviors on a list that is “neither exhaustive nor determinative”, may seem like an invitation to fail. However, another attendee at Behavox’s sellside roundtable found the approach need not be as oblique as it first seems. “It makes sense to look beyond the definitions and stand back and say, ‘Is this acceptable market conduct?’ This should feed into your risk assessment.” Goodman added that firms’ risk assessments could also be informed by a cursory look at guidance such as the Market Watch series, and by taking note of previous enforcement actions.
“Businesses change and interpretations change so it pays to ensure that risks aren’t allowed to creep in unchecked.”
Market Watch 58 instructs firms to ensure they are properly considering their obligation to counter the risk of financial crime, in a statement that somewhat blurs the lines. Radar understands firms are generally working more closely with financial crime teams and assisting them on projects; particularly those concerning insider trading and market manipulation. In stark contrast to the complexity and non-compliance surrounding many areas of MAR, a pro-active relationship between regulatory and financial crime teams may already have taken hold, with Goodman suggesting that some firms have in fact integrated the two.
“Ignorance of the requirements of MAR, or the absence of intent to commit market abuse, are not a defence to breaches of MAR.”
The right state of mind
There’s little doubt that the succession of Market Watch features carries a new, sterner energy and focus from the regulator. MAR and MiFID II have long been at the top of the “to do” list for firms and FCA has grown impatient; it wants to see a shift from “to do”, to “done”.
FCA reminded firms of a warning by director of oversight Julia Hoggett, in November 2017. In this speech, Hogget said “abusive conduct committed in ignorance of the rules can be every bit as serious in its consequences as deliberate, dishonest conduct, and we will pursue it accordingly. It is important to recognise that ignorance of the requirements of MAR, or the absence of intent to commit market abuse, are not a defence to breaches of MAR.” It is with this message in mind that firms should proceed.
This was reinforced in February, when she gave another speech on a mix of issues but with similar themes. It offers some valuable clarification for firms who, having read Market Watch 56-58, have been left unsure about where this is all going.
Ultimately, Hoggett calls for firms to have the “right state of mind”. It is clear that the regulator wants the market to be more curious and more imaginative in its approach to compliance. Those in the control areas must work with other teams to “evolve [their] assessment of the risks” and support staff to “conduct business appropriately”. Simply ticking pre-existing boxes is no longer enough.
It certainly feels like the honeymoon is over.