Last month, the Financial Conduct Authority (FCA) published its Market Watch 69 in which it discusses firms' arrangements for market abuse surveillance, drawing on its observations from engaging with small and medium-sized firms. When firms assess what is appropriate and proportionate for their specific business, it would be worth taking the FCA's observations into account– particularly as the FCA has said (in its recently published Strategy 2022-25) that over the next two years it intends to improve its ability to detect market abuse through a significant upgrade in its market surveillance systems. In a more recent announcement the FCA outlines the work it is doing to tackle market abuse and makes it clear that this is an area of "increasing intensity, scrutiny and sophisticated action, in which criminal prosecution is one of several concurrent strategies being deployed" adding that it is "determined to tackle market abuse and insider dealing wherever there is evidence of it whether this is through the courts or [its] own powers".
In this most recent edition of Market Watch, the FCA also provides guidance on firms' investigations into potential market abuse by their own employees.
Observations on market abuse surveillance
Market abuse risk assessments
A comprehensive, accurate and up-to-date market abuse risk assessment can help ensure effective surveillance coverage. The FCA says that the most effective assessments involve consideration of the different types of market abuse and how they apply across different areas of the business, otherwise the firm may not be able to adequately identify market abuse risks and align their monitoring programme to them to ensure effective surveillance.
Specifically, when assessing market abuse risk, firms should consider the nature of different:
- asset classes.
- instruments traded.
- types of business activity (e.g. discretionary vs execution-only, client vs house trading).
- methods of execution (e.g. electronic vs voice-broked markets).
- trading platforms (e.g. lit vs dark books, central limit order book vs auction).
More generally, the FCA observes that low trading volumes in certain business areas does not mean that risks in that area can be discounted.
Firms should review and update their systems as necessary to ensure they remain effective in the context of risks arising from changes in their business.
Order and trade surveillance
Firms should consider the different characteristics of different asset classes and instruments, before applying this information to calibrating alert scenarios, so they can ensure they can effectively identify potentially suspicious activity, while reducing false positives. As an example, for a change in price in an AIM-listed stock, a FTSE 100 stock, a government bond and a corporate bond to be considered notable and worthy of review, the size of the price move will usually be quite different. This means that applying generic calibration across, and within, asset classes - where the nature and scale of the metrics involved (such as price movement) are significantly different - will result in ineffective monitoring (the threshold is set too high/too low for some instruments), or it may generate a significant amount of "noise" (where the alert is calibrated to the most sensitive of the financial instruments).
Although third-party system functionality in areas such as tailored calibration has progressed in recent years, the FCA is concerned that firms are sometimes unaware of these developments and so may not be making the best use of the technology. Where firms use vendor-supplied systems, they should ensure they understand how alert scenarios work, otherwise they may fail to identify gaps or weaknesses in their surveillance.
Even when some firms have identified insider dealing as a key risk and monitor for it, they inhibit the surveillance system's effectiveness by applying inappropriate thresholds to calibration – for example, only alerting on trading that has taken place 24 hours before the release of inside information (the 'lookback period'), without considering the length of time that inside information might exist before its release. Proper consideration of the surveillance thresholds will help ensure appropriate and proportionate surveillance.
Firms should monitor all orders and trades, including cancelled and amended orders. The surveillance of orders that do not result in a trade can be critical in identifying certain forms of market manipulation, such as those that involve false or misleading signals to other market participants.
Weaknesses lie in some firms' review of surveillance exception alerts (e.g. only escalating and considering reporting where they identify an obvious link between the client and the issuer or source of the inside information). While the existence of such a link may be an aggravating factor in assessing whether reasonable suspicion of market abuse has been reached, its absence does not necessarily serve as a sufficient reason to close alerts.
Whether firms are using an in-house solution, a vendor-supplied solution or a combination of both for trade surveillance, firms must periodically review their arrangements to ensure they remain effective. This will include surveillance alert parameters and logic, as well as work undertaken on the analysis and escalation of alert outputs.
Policies and procedures
Firms should have clear, detailed and up-to-date policies and procedures. These may provide a helpful reference point for staff and assist with work in areas such as alert review and escalation. Where policies and procedures direct analysts reviewing surveillance alerts to look for signs of market abuse, they should provide guidance on what these signs might be, or what materials/information to use or consider. Where there is no such guidance, the information considered in alert review may be insufficient or incorrect, and alerts may be inappropriately closed rather than escalated.
The FCA appreciates that while firms may be wary of being over-prescriptive, and may want to encourage initiative in their staff, they may want to consider if there are benefits in creating policies and procedures that provide a level of guidance in how work should be undertaken.
Outsourcing
The FCA recognises that firms may outsource aspects of their surveillance to another part of their organisation, or to a separate organisation. However, it warns against there being a limited understanding and/or oversight of the surveillance taking place (such as inadequate knowledge of alert logic and calibration; weak or no quality assurance work on triaging alerts; and insufficient management information). It also warns against UK Compliance teams having inadequate understanding of the surveillance undertaken at group level. MAR does not preclude outsourcing arrangements, but the responsibility for identifying and reporting potential instances of market abuse to the FCA rests with the UK entity subject to MAR obligations.
To ensure that all aspects of surveillance are appropriate, adequate oversight and governance over the arrangements are critical. The FCA reminds firms that where there is delegation to a separate organisation, the person delegating should have sufficient expertise and resources to oversee the services provided.
Front office
The size of some firms may mean staff perform dual roles in the front office and as part of Compliance – i.e. in both the first and second lines. Where this is the case, the FCA says that firms may want to consider whether they have adequately assessed any potential conflicts of interest and taken steps to mitigate them.
The FCA warns that relying solely on front office staff for monitoring market abuse – sometimes as mitigation for a limited or absence of surveillance in a second line Compliance function – may lead to several risks (e.g. potentially suspicious activity is not consistently identified and escalated; staff know when trading activity might be escalated and might share that knowledge with clients; and staff whose remuneration is linked to client business might be conflicted in considering whether to escalate).
To ensure staff act appropriately, firms should consider whether their market abuse training is effective and tailored to the risks associated with the desk, asset classes traded, client types and other relevant factors. Front office staff may also benefit from clear escalation policies and senior management support in helping them make appropriate decisions.
Countering the risk of market abuse-related financial crime
A firm must have policies and procedures to counter the risk a firm is used to further financial crime, specifically criminal market abuse, as per SYSC 6.1.1R. In December 2018, the FCA published Chapter 8 of the Financial Crime Guide setting out guidance for firms in relation to market abuse-related financial crime. To comply with their obligations, firms would benefit from ensuring they have a good understanding of the risks that are relevant to their business, as well as robust controls to mitigate those risks.
In situations when front office staff know a trade would constitute market abuse (e.g. when a client discloses, pre-trade, that they are in possession of inside information), submission of a STOR following execution is not sufficient to meet regulatory obligations: the FCA reminds firms that front office staff should consider whether it is appropriate to execute the trade, in accordance with SYSC 6.1.1R. To ensure staff understand their obligations and act accordingly, it may be beneficial for firms to include this topic, along with relevant examples, in their market abuse training. As before, the clear and unequivocal support of senior management is essential.
Investigations into potential market abuse by firms' employees
The FCA states that in instances where firms identify their own employees involvement in potential misconduct/market abuse and carry out a detailed investigation, firms may want to determine whether steps such as disciplinary measures might be appropriate, while taking care not to inform the subject of the STORs or anyone else who is not required to know, that a STOR will be submitted. The FCA reminds firms subject to Article 16 of MAR that they should also consider the requirement to submit a STOR without delay, once they have a reasonable suspicion that the relevant conduct could constitute market abuse. This may be before the full internal investigation has been concluded. If appropriate/necessary, any information not available at the time of the submission can be communicated to the FCA at a later date.
Next steps
The FCA's latest Market Watch provides useful guidance for firms on market abuse surveillance and firms would be well-advised to check that their arrangements, systems and procedures measure up and to remedy any aspects which fall short.
Our Financial Services Investigations and Enforcement team has extensive experience in advising on market abuse and control frameworks and is here to help with any questions or concerns you may have.
Authored by Claire Lipworth and Daniela Vella.
