Last year exposed some inconvenient truths and proved a watershed year for conduct risk, with a string of fines, reminding trading firms of the true cost of non-compliance. Individual accountability rules vary by jurisdiction but in Europe The Senior Managers & Certification Regime (SMCR) adds the threat of business heads facing specific enforcement for conduct failures within their teams.
The need for supervision
Within the front office, the first line of defense supervises sales and trading. This construct, with 3 lines of defense, was driven from the 2013 Position Paper of The Institute of Internal Auditors (IIA) and persists in many organizations today, but is one that firms now need to revisit since the IIA 2020 update. The revised IIA standards reflect and reiterate the need for front-office responsibility for the supervision and monitoring of their own actions. This doesn’t negate the need for an independent surveillance team, the second line of defense, but suggests that firms need to adopt a framework where both the front-line and an independent team work together to ensure that an institution's market conduct is appropriate.
The IIA update coupled with SMCR means bank senior management can no-longer rely on the idea that it is another person’s job to monitor trading behaviors . All institutions are aware that although regulations covering market abuse and misconduct are often principles-based, the regulators’ response to failure is explicit.
The change in IIA standards is consistent with the way that OTC markets have evolved. The adoption of the FX Global Code (FXGC) is a response to many industry factors including scandals relating to fixing and last-look, yet it was in many respects ahead of its time. Bodies like the The Fixed Income, Currencies and Commodities Markets Standards Board (FMSB) and Global Foreign Exchange Committee (GFXC) have promoted best practices within the group of organisations they serve, but the weight of central banks, each pushing for compliance with FXGC within their jurisdiction has resulted in thousands of voluntary signatories.
By signing the FXGC, a financial institution is declaring an intent to adhere to best practices as outlined in the document text. Ideally, member firms demonstrate their commitment through an independent audit to ensure adherence. While seemingly honor based, we see regulators require banks to demonstrate compliance with the code as part of their enforcement remediation, in such actions as the 2019 settlement agreement of The Ontario Securities Commission with the Royal Bank of Canada. In the next 18 months we can expect more banks to put themselves forward for self certification.
Whilst every firm has embedded a surveillance function to monitor for market abuse, the wider range of best practices outlined in the code stretch way beyond the scope of surveillance. Demonstrating compliance to these broader principles-based requirements, are beyond the scope of the automated tools that exist today. As FX banks focus on ensuring their controls around regulations and voluntary codes are robust, it is essential that the technology they rely on is suitable now and in the future.
The rise of remote working
With salespeople and traders working from alternative offices or from home, the need for improved supervision in FX has increased significantly. Existing policies that were effective when people were physically located on trading floors are lacking when the same staff are working remotely.
E-comms monitoring cannot detect the use of personal cell phones or communications on unmonitored social channels. Physical and human deterrents that exist in the office environment cannot be replicated by a firm at a person’s home. At the same time, remote workers have been challenged to perform with limited access to necessary systems. Compliance monitoring teams nimbly implemented new flexible policies to address these challenges while many of these risks remain only partially mitigated. It is clear that despite a significant shift to remote working, and in some cases, because of it, the FX market remains volatile and daily volumes continue to grow.
Principles Vs Regulations - the spirit and the letter of the law
For any firms thinking that the pandemic has resulted in some leniency by the regulators, this is far from the case. For example, the Financial Conduct Authority (FCA) in the UK has been clear about its intention to ensure any market abuse that takes place during the Covid-19 pandemic is tracked down and addressed.
Regulators are taking a less prescriptive and more principles-based approach to trading controls and FX banks are being urged to go beyond what is written in regulations, and demonstrate they also understand and adhere with their spirit.
It is insufficient for a firm to demonstrate compliance in equities (where electronic trading rules are highly prescriptive) but allow an electronic FX business to trade without the same internal scrutiny. This approach places firms under pressure to ensure their conduct – and ability to evidence it – is of the highest standard, satisfying the most stringent interpretation of any applicable code or regulation. In the past, too many financial firms have waited for such specific direction from regulators before bolstering existing checks related to principles and codes, or rolling out new ones. This is now changing.
With regulations such as Dodd-Frank in the US and SMCR in the UK making individual accountability a reality, senior managers are now personally liable for any failure to adhere to regulations governing conduct. SMCR has made senior managers who are responsible for FICC trading more scrupulous about regulatory and conduct risk. In many cases this has been a key factor behind decisions to invest in technology platforms. The first line of defense has traditionally monitored trades for compliance with regulations, and more recently includes best practices around issues like last look and spread, that require a firm to act consistently, fairly and proportionately.
Third party platforms are able to provide supervisory desks with objective independent assessments, as well as an audit trail that they are adhering to best trading practices and standards, including the Market Abuse Regulation (MAR), the FXGC and the FMSB.
Applying advanced technology to surveillance
As traditional surveillance solutions have started to cover more use cases, the number of alerts that they produce has increased, resulting in what some compliance teams call “alert fatigue.” Sophisticated surveillance tools have created a solution for this - automatically closing some of the alerts through AI /ML – but this really just masks the problem.
Contrary to conventional opinion, advances in technology mean that principle-based regulatory regimes can be translated into prescriptive checks. Firms can independently analyze algo and human trading activity – at scale- but it requires a different approach.
The first step is understanding the principles and standards, such as those included in the FXGC, and correctly defining them, which results in better analytics that go beyond the letter of the law. By combining modern and flexible technology with industry knowledge and experience, some firms like Ideal Prediction have been able to codify principles-based documents to provide structured analytics from raw trade data. This improves supervision and surveillance, enabling evidence that firms are trading in a responsible and ethical way.
Applying innovative engineering to conduct risk further requires that data is automatically ingested from various sources, across multiple asset classes, and in a myriad of different formats, and then normalized by the provider, saving firms many hours of data management issues and headaches. Such technology advances allow providers to mitigate regulatory risks and deliver real-time analytics, data security, and visualization customized to each user. Compliance and supervision teams rely heavily on this technology to monitor trades and behaviors. As Covid changed the way many people work, the need for flexible technology increased, as clients want to quickly refine services and reports and add new features.
Visualization is a core component of any modern surveillance technology, enabling supervision and surveillance teams to quickly cut through huge volumes of data to identify any suspicious activities, or evidence adherence.
Systems, such as Ideal Prediction’s Scope, alert financial firms to potential issues of last look misuse, for example, by examining the order response times on trades. Not only does a system need to check if there are long response times but why, for instance, in response to sudden market moves. Checks for spikes in order throughput and even small breaches of risk limits, can be enhanced by comparing this with peer group activity enabling banks to investigate the causes.
Many of these flagged behaviors are usually not malicious in intent, but may look cosmetically bad, which means that firms need to understand any issues and document them.
Independent Audit Trails - You cannot grade your own homework
Identifying nefarious trading activities is vital, as is identifying behavior that has the appearance of impropriety. This is why more trading firms are turning to third party systems, where there is little to no risk of a lack of objectivity skewing results and audit trails. Equally important is the storage of records. Documentation around trading activity, storing the flags a system produces in a centralised location, tracking the actions taken, and providing an immediately accessible audit trail in the event of an internal or regulator investigation are vital to mitigating regulatory risks.
During an audit or investigation, it can be hard for traders and their supervisors to explain historical decisions and evidence the processes they followed. For example, if asked, “How did you check that the limit you had in place on May 18 last year was really 15 orders per second?” These types of queries are hard to prove unless there is access to evidence from every single year that you are adhering to a process.
Future proofing surveillance and supervision
As the Covid-19 pandemic continues, some traders have returned to the office, but others are expected to work from home and other locations for some time to come. In this working environment, compliance and supervision teams need to continue to enhance oversight to better detect and investigate nefarious trading activity. In general, traditional out-of-the-box first and second line surveillance tools are limited in their flexibility, lacking the breadth and specificity to incorporate FX codes and standards to which banks need to adhere.
Looking to the future, technology platforms that will thrive are location and asset class agnostic, highly adaptable, analyzing the spirit as well as the letter of the law.
In essence, trading firms must pick a technology partner that is future proof. In the mitigation of conduct risk, it is vital to adopt third party tools to enhance internal systems and to evidence independent objective audit trails. Equally important is to work with providers who are skilled at implementing the more nuanced approaches needed to adhere to principle-based codes of conduct.