While it may be impossible to completely rid the financial markets of abusive practices like front-running or painting the tape, regulators and exchanges must compete in the technology arms race if they wish to limit the impact of deceitful trading.
Abusive trading – the practice of manipulating prices, typically through illicit use of market information, before placing an order – can be hard to spot, especially during volatile market conditions when spikes in volume and value are not uncommon.
And because abusive trading is hard to define and identify, it is inconsistently and subjectively regulated. As such, practices like painting the tape, where a trader sends streams of orders to the market before modifying or cancelling them to give an impression of market activity, continue largely unchecked. The recent growth in high-frequency trading has only compounded the difficulties of policing trading.
“There will always be clever, more tech-savvy traders that will find contentious methods of trading,” said Adrian Fitzpatrick, head of investment dealing, Aegon Asset Management. “The regulators try and play catch-up and succeed in closing some of the open doors, but they will always struggle.”
In a trading landscape increasingly dominated by sophisticated technology, it is imperative that regulators and exchanges have equal, if not better, information and systems than market participants, with the ability to detect abusive trading behaviours before the offender has a chance to capitalise on them.
“Regulators have sophisticated systems to gather information and look historically at what has happened. But by the time the regulator identifies and investigates a problem, people have already lost out and the abusive behaviour has occurred,” says Giles Nelson, senior director of strategy at Progress Apama, the algorithmic trading and complex event processing division of Progress Software. “There is now a push for those systems to be more real time to enable them to respond more quickly before the market has moved. It also sends a signal to those firms that their behaviour is being examined and it is more difficult for them to get away with it.”
Nelson estimates that 30% of merger and acquisition activity has been subject to insider trading and has become a particular focus for regulators in recent times.
Rather than the more conventional method of probing activity after market close, patterns of market abuse can be programmed into detection and monitoring tools while exchange feeds can be analysed for abnormal trading behaviour in real time. Although historical analysis allows time for a more in-depth look at trading patterns, real-time tools allow regulators and exchanges to make their own updates to ensure they can detect the latest form of market abuse.
“Exchanges and multilateral trading facilities need to analyse trading activity in real time,” said Yann L’Huillier, chief information officer, Turquoise. “Complex event processing systems make it possible to stream multiple sources of data and correlate this in real time for about a tenth of the cost it takes to do this in batch at the end of the day, in a much more reliable way.”
A long-term concern of buy-side traders is front-running, typically the advance placing of orders by brokers (or other market participants) for their own proprietary trading account using information received from a buy-side order.
The FSA recently banned and fined Nilesh Shroff, a former Morgan Stanley trader for “deliberately disadvantaging his customers by ‘pre-hedging’ trades without their consent”. Shroff was fined £140,000 and banned from performing any regulated trading function after he was found to pre-hedge – a practice similar to front-running – on at least seven occasions between June and October 2007.
Aegon’s Fitzpatrick says that this kind of activity is a common worry for buy-side traders, and notes that sales traders that can utilise electronic tools with discretion are highly sought after.
“When you send an order to a sales trading desk, the first thing many will probably do is to announce it across the trading floor,” said Fitzpatrick. “There is still a demand for good quality sales traders who see algorithms and electronic trading functionality as just the tools to facilitate a trade.”
Most agree that the battle against abusive trading practices will never be won, but the arrival of MiFID has unleashed a raft of new execution options for investors to choose from. Fitzpatrick says that, for most traders, using intuition and making full use of these options are the main ways to militate against unfavourable trading practices.
“By using common sense, utilising dark pools and other execution channels, you can minimise your chance of exposure and information leakage,” he says. “Risk pricing, where available, also cancels out a lot of the argument. If you’re happy with the price offered by your broker then you have nothing else to worry about.”
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