Brokers - the key to market integrity in a global market?

Michael Aitken and Andreas Furche, Capital Markets Cooperative Research Centre Ltd

In contrast to stock exchanges which are responsible for their own marketplaces, international broking firms are active across a large number of markets. In doing so they hold confidential trading data from activity across many markets, which is the key to detecting irregularities. Brokers are in fact the only organisations who hold this data on a multi market level. Exchanges only see the detailed picture of their own market, and data service providers like Bloomberg or Reuters have no access to the most important restricted data components of market transaction data.

In many articles dealing with the issue of market surveillance/integrity, exchanges and regulators are assumed to play the key role in ensuring market integrity. Brokers and their clients are presumed to be the adversaries who need to be policed in order to prevent or prosecute violation of market rules and national securities legislation.

If this is indeed the state of affairs then we suggest that market integrity is already a lost cause. We prefer to believe that market integrity is an attainable goal and, associated with this, that the violation of rules and regulations is not endemic at an organisational level within a broking firm. Rather it is the province of a limited but determined number of individuals (employees and/or clients) who act inappropriately for personal gain. They not only violate market rules and national legislation, but they also contravene broker internal policies and trading rules that are in place to protect the broking firm, and in turn the marketplace. As an organisation, we contend that it is overwhelmingly in a broker's interest to abide by and even contribute to the development of market rules and legislation in order to protect the firm from financial and reputational risk. Moreover, to contemplate market integrity without the direct involvement of brokers is akin to a forlorn effort.

Mutual Obligation

The purpose of this article is to suggest an approach (and highlight a working solution) to market surveillance/integrity which actively encourages brokers and exchanges to work together, sharing both know-how and technology. For convenience we refer to the approach as 'Mutual Obligation'. In brief, Mutual Obligation implies that it is as much an obligation of the broker to do what they can to prevent rule violations as it is an obligation of the exchange, and that brokers have a vital role to play in ensuring cross-market integrity.

For almost a decade now, an Australian research group (now incorporated as CMCRC) has been advocating that the parties with the sophisticated systems to detect abuse (until now mainly the regulators) should make public, as soon as practical, any hint of unusual trading behaviour. To date these suggestions have largely been rejected based on concern by exchanges and regulators that if they did release the consequences of their automated detection mechanisms, 'integrity challenged individuals' (ICI) would quickly second guess the alert technology and its parameters and seek to circumvent them. While this may be true, what is equally true is that the root cause of such concern is the fear of being unable to keep pace with the ICIs, many of whom are suspected by regulators of either coming from within the front-office of broking houses or providing tacit support to third parties for which the brokers act as intermediary.

In our opinion, however, the idea of not sharing technology and its outputs is far worse than the alternative and indeed plays into the hands of ICIs in that it encourages a misguided complacency among exchanges/regulators that they alone can maintain market integrity. It also leads to suboptimal behaviour by brokers. Instead of directly benefiting the exchange with more effective internal enforcement of exchange rules, compliance divisions in broking firms spend their already thin resources trying to second guess what the exchange may in fact be looking for, not for their firm to avoid the rules, but just so they can enforce them.

In line with the principle of Mutual Obligation, we suggest the exchange recognise the broker's compliance divisions as allies, and accept that more effective tools for the compliance officer in the broking firm means more effective market surveillance, and ultimately improved market integrity. In this sense exchange surveillance divisions and brokers themselves should if possible share their technology and know-how rather than keep it secret.

For the last two years the CMCRC has sought to operationalise this approach. Through a new company, Capital Markets Surveillance Services (www.cmss-systems.com), the CMCRC has begun providing technology to compliance divisions of broking firms providing them with advanced real-time surveillance capabilities. At the same time, the CMCRC, by enlisting the technological support of SMARTS Pty Ltd (which has provided real-time surveillance systems to 20 world exchanges and regulators) has sought to give brokers similar real-time capabilities as currently exist within modern surveillance divisions, albeit without compromising the secrecy of patterns in trading that exchanges and regulators are looking for with their systems.

Limited technological sophistication

It may come as a surprise to many, and it certainly did to members of the CMCRC when they began this work, that many, if not most compliance divisions of broking firms are currently not capable of real-time market surveillance. Furthermore, surveillance procedures are distinctly manual in nature, haphazard in coverage and essentially reactive rather than proactive in design. What automation there is mostly consists of a set of rudimentary data extractions and relatively simple tools often built and maintained in-house by the internal information technology (IT) division.

A key reason cited for this state of affairs is cost. Compliance is a cost centre dependent upon the financial support of the very trading divisions that they seek to monitor. Furthermore, compliance has to compete for scarce internal IT resources with the trading desks, and whenever this situation occurs, the priorities are clear: revenue production must come first. Not surprisingly therefore the average technology budget in compliance departments pales by comparison to the sums spent in the front office. But the technology requirements for effective surveillance are far from trivial. In an international broking firm, even obtaining access to the trading data requires the ability to read and interpret more than 100 trading data feeds, usually all different in format not to mention content.

The first real-time compliance service

Responding to the challenge, the CMCRC has conducted a research exercise based in the Australian markets to determine whether it is possible to provide a common solution to all brokers, and more importantly one that is based on the same technology used by the local exchanges. Since June 2001 the CMCRC has provided real-time surveillance services for the compliance divisions of broking firms. The ultimate object of the technology is to provide senior compliance offices in broking firms with the capability to simultaneously and in real-time monitor activities of their traders and clients in any market in which they operate. In the last 12 months the systems has been successfully expanded into New Zealand, Hong Kong, Norway and Singapore providing the capability for senior compliance officers at the click of a key stroke to move instantaneously between these markets with the automated alert detection routines proactively identifying trading behaviour of interest[1]. The technology automatically detects a large number of suspicious patterns for the compliance officer to investigate[2]. It automates a significant and monotonous part of the compliance officer's tasks in real-time, and ensures that limited compliance resources are effectively directed towards issues that need further attention. All IT intensive tasks such as data extraction, handling, and conversion, are effectively outsourced in this process. A crucial part of this new approach (hereafter referred to as CMSS) is an attempt to secure the data to provide the service from one data supplier, often the exchange, so that instead of writing individual data connectors for each business, one data connector can be built and shared among many parties significantly reducing the cost of the exercise.

Definition of exceptions to be reported by the system, or the creation of 'Alerts', is done by the broker together with experienced surveillance staff retained by CMSS, further sharing resources and reducing cost. Use of the ASP model means that costs for hardware and operations are being shared across firms. Further savings result from a strategic alliance with SMARTS Pty Ltd. and CMSS has been able to share the same state of the art technology platform that is used by many current exchanges and regulators for surveillance, without the need to develop technology from scratch. Finally, through conscious cooperation between brokers, the development of the key part of the system, namely the definition and implementation of the patterns of events that represent an 'Alert', is shared among the brokers.

However, even though CMSS offers the possibility for each broker to create and run their own 'Alerts', in the market where CMSS has been in use the longest (namely Australia, for approximately two years) the brokers have chosen not to do so. Instead they have adopted an approach best described by the phrase 'There but the Grace of God go I' or 'Safety in Numbers'[3]. They have decided to share Alert development in the belief that demonstrating a conscious and consistent attempt to address a problem situation lessens the chance of regulatory enforcement being enacted against any single party. This has made it easier for CMSS to share surveillance expertise across firms that otherwise are fierce competitors.

Another interesting benefit is also beginning to emerge. Whereas initially there was widespread scepticism associated with involving the exchange/regulator in the process, there is now general acceptance among the 17 brokers (including 10 internationals) using the service in Australia that it makes sense from time to time to bring the exchange/regulator in for direct consultation, especially when it comes to understanding where to set the cut-off point for parameters in particular Alerts. Notwithstanding these significant shifts in position, the idea of the exchange/regulator contributing directly to the process by providing definitive advice on where to set such parameters remains elusive. While providing tacit approval of the approach, the Australian regulatory authorities are yet to fully engage. If nothing else this simply indicates that change is seldom implemented overnight and this type of change could take several more years before it is fully effective. Under this new scenario largely ineffectual guidance notes, which have formed the basis for information transfer between regulator and broker to date, are expected to be replaced by more practical guidance on where to set parameters. The greater certainty that CMSS has begun to bring to the process has all parties feeling more positive regarding their roles in maintaining the integrity of the market, with at least one broker having self-reported breaches, demonstrating a willingness to fully engage in the process.

Clearly a key issue in order for this process to succeed is the extent to which ICIs within a broking firm, or within the customers of a broking firm, can access and use the technology now available to the firm, to avoid detection of their activities. While this is possible in principle, such outcomes are mitigated by a number of measures:

• Compliance officers not sharing the information on parameters and cut-off points for Alerts with trading parties.
• Frequent changes to the cut-off points of the alert parameters.
• Proactive action by CMSS (on behalf of the group) to determine whether traders in some firms appear to be trading with this knowledge feeding into new Alerts.
• Continuous development of new Alerts.

Market integrity that relies on brokers

A particular problem that more than any other highlights the importance of brokers in assisting in the process of market integrity is cross-market activity which is now a significant feature of the capital markets landscape worldwide. Exchanges usually run a single marketplace, or at best belong to a strategic or corporate group of exchanges. Brokers, in particular a handful of international brokers, operate across hundreds of marketplaces. As a result they are in a unique position to build a 'multi market' picture of the world's financial markets. While individual market authorities are now adept at monitoring their own markets, an important question is: What happens if irregular or manipulative trading is conducted across several markets, particularly international markets? Who for example checks that for international cross-listed stocks the prices are not set (manipulated) in one market (say Australia) to ensure that clients in another market (say London) trade at particular prices?

It is immediately clear that many activities that are detected or prevented on a single market, such as front running the client, or manipulating a price, cannot easily be prevented by a party with responsibility for one market only, when they occur across multiple markets. And yet cross-listed securities and/or substitutable financial instruments such as options, warrants and futures on underlying equities, make the possibility of such action a reality.

An interesting example that was detected and became public in the last five years was the case of trading by Nomura Securities in the Australian equities and futures markets in June 2001. In this case, legal action by the Australian Securities and Investments Commission found Nomura employees in London and Hong Kong to have breached Australian securities regulations. Though not technically subject to the jurisdiction of the Australian regulator, Nomura in this case accepted responsibility for the actions of its traders in the Australian marketplace by accepting an enforceable undertaking. In the process it took significant reputational fallout from the circumstances which were well publicised in the media, not only in Australia.

In the Nomura case, fortunately, the responsibility of the regulator was still clear. Both markets, while separate organisations, ultimately fell under the responsibility of the Australian regulator, even though the individuals involved in the breach were not. What would happen in this kind of scenario if the markets involved were in different countries? The probability of it even being detected by one of the responsible regulators would be very low[4], because this regulator would only see a limited part of the data picture. The probability of it being prosecuted across different jurisdictions is probably close to zero. Yet, with international securities trading and cross-listing increasing, the issue of integrity of 'The Market', the network of financial marketplaces, should be at the heart of its participants.

So who should we expect to police this kind of 'cross-market integrity'? There seem to be two options. One option is to alert the exchanges and/or regulators in many countries to the issue, to demonstrate the latter through examples (which may include disasters waiting to happen), to hope for regulators or national representatives to form consensus on what to do about it, then wait for such an initiative to be implemented. We suggest this would be a difficult and tortuous route to travel if for no other reason than jurisdictional problems. Further, competition among exchanges reduces the likelihood of them cooperating as a group to achieve this purpose[5]. The other option, which we believe to be a more practical one, would be to enlist the support of brokers who act across multiple markets, and have a political and reputational risk to guard against, to help identify irregular possibly illegal conduct.

It remains a fact that, for now, brokers are the only organisations with easy access to the information required to conduct the necessary monitoring across markets, albeit for their own trading activities. An alliance among international brokers for compliance is not only practical, it has now been proven feasible. CMSS is now being used by at least three international brokers in four international locations. This is expected to extend significantly over the coming years, proving not only the feasibility but the desire of brokers to actively participate in the process of ensuring market integrity. This suggests to us that the key to market integrity is not only regulators and exchanges, but importantly includes brokers, particularly their compliance divisions.

Notes

Michael Aitken is Professor of Capital Markets Technology at the University of New South Wales in Sydney and CEO of the Capital Markets Cooperative Research Centre (CMCRC). He is leader of the CMSS research project. Dr Andreas Furche is Chief Technology Officer of the CMCRC.

The Capital Markets Cooperative Research Centre (CMCRC) is the world's largest research centre dealing exclusively with the use of technology to detect securities market fraud. Established in 2001 by the Commonwealth of Australia, four Australian Universities with the industry assistance of SMARTS Pty Ltd, the CMCRC is the architect of the CMSS, an enterprise that has been experimenting with the provision of on-line real-time fraud detection and market analysis services to brokers.

Note that trading behaviour of interest not only encompasses potential breaches of exchange rules of national securities regulations but almost anything the compliance officer desires. This could include unusual size transactions or trading in securities that traders don't normally trade.

More details on the technology (and alerts) can be obtained by contacting Capital Markets Surveillance Services Pty Ltd in Sydney or London (see www.cmss-systems.com).

In a recent case illustrating this approach, after Etrade Australia was fined by the ASX for permitting its electronic access clients to continually tick up the price of a stock on very small volume, CMSS developed an alert to target this type of behaviour and with Etrade's consent implemented it for all Australian CMSS customers.

As it was there was no technology sharing among the two market authorities, namely, the Australian Stock Exchange and the Sydney Futures Exchange. All they had was a Memorandum of Understanding for the sharing of information in circumstances where a problem was identified. The question is: How is a problem to be identified in the first place?. We suggest that the obvious solution is to have both markets cooperate in the building or buying of technology across their respective markets. Note that the only reason this situation was detected was because of its size.

A similar type of problem may also ultimately prevent regulators from this achieving this purpose. Aside from the issue of particular regulators seeing cooperation as a threat to their very existence, many countries jealously guard the information emanating from securities markets under national secrecy laws. Overcoming national sovereignty makes the problem 'A Bridge Too Far' at this stage.