Market abuse and misconduct

October 16, 2018 | Financial services

Market misconduct

Market misconduct in its simplest terms is the deliberate attempt to interfere with the operation of the market. The interference can take many shapes, however; the ultimate goal ranges from making money to preventing losses. Examples of market misconduct include but are not limited to insider dealing, false trading, price rigging, the disclosure of information about prohibited transactions, the disclosure of false or misleading information inducing transactions, stock market manipulation, and other similar actions where market interference results in profits.

A recent example is the London Interbank Offered Rate (LIBOR) scandal where traders from various banks colluded to influence the final average rate. This occurred through mutual agreement amongst themselves to submit rates that were either higher or lower than the actual market estimates. Regulators are responding through fines and criminal charges against key financial services institutions and employees globally. An example of this is the impact of the LIBOR manipulation, to-date more than USD 14B has been levied across the institutions which were involved. Global regulatory scrutiny of wholesale principal sales and trading businesses has increased as perceptions of unfair treatment of clients, abuse of firm positions, and/or failure to maintain market integrity continue to grow.

Industry impact

Despite the widespread media attention, the LIBOR scandal is not the first of this kind. A recent report by the FICC Market Standards Board “Misconduct Patterns in Financial Markets” published in July 2018, points to cases of financial misconduct as far back as 225 years ago. This study found seven categories of financial misconduct including price manipulation, inside information, circular trading, reference price influence, cooperation and information sharing, improper order handling, and misleading customers.

In November 2017, a study released by the Federal Reserve Bank of New York entitled “Misconduct Risk, Culture, and Supervision” examined the cause behind the persistence of misconduct and stated that “misconduct is the result of wider organizational breakdowns. Often, large numbers of employees and managers were either complicit in improper conduct, encouraged it, or turned a blind eye to troubling behavior. This suggests a different issue.”

Organizations now need to invest in ways to understand and uncover the root cause of misconduct and proactively respond.

While there are many considerations when managing market misconduct, this blog will highlight three considerations, which we believe will start the right conversations. These include:

1. Address conduct vulnerabilities proactively
2. Build the right governance and framework
3. The use of artificial intelligence (AI)
    

Address conduct vulnerabilities proactively

A critical starting point to building out an appropriate and targeted conduct risk framework is building a granular inventory of known and suspected conduct vulnerabilities. These vulnerabilities may exist across four dimensions including:

• Product: Are product terms and conditions clear and easy to understand?
• Distribution: Are sales staff and sales channel incentives designed to drive the right behaviors, based on fair customer outcomes rather than sales volumes?
• Customer experience: Are there processes in place for proactively identifying and protecting vulnerable customers?
• Systems and governance: Are technology solutions and systems support designed to achieve the right (fair) customer outcomes?
   

Build the right governance and framework

When considering strengthening conduct risk management, a fundamental starting point is ensuring that the right framework of policies, codes, and standards are in place to direct the expectations for proper conduct within the organization.

In addition to this unifying framework, firms should pay close attention to the control environment targeted at points of conduct risk vulnerability. Collaboration and coordination between front office businesses and control functions including compliance, operational risk, human resources, operations and technology, as well as legal and internal audit, is key to an effective conduct risk management framework. Indeed, understanding and agreeing upon how to conduct risk is best managed across all three lines of defense can bring valuable clarity to this topic. Key questions to ask include:

First line of defense:

• Do front-line employees understand clear roles and accountability?
• Is information on conduct captured at this level and communicated?
• How are employees balancing commercial drivers and market interests?

Second line of defense:

• How can front-line traders and employees be motivated against misconduct? Can policies be put in place? Are incentive structures more effective or penalties?
• Do managers understand the business segments to address risk properly?
• Can managers identify which employees are more at risk?

Third line of defense:

• How can success be measured by an independent internal audit team?
• How can an internal audit team stay independent but also be involved enough with first and second line of defense to challenge them on their behavior?
   

The use of artificial intelligence

Lack of oversight, surveillance or predictive capabilities within financial institutions (FI) is a factor in many conduct-related issues. The ability to quickly identify and address issues before they become systemic is fundamental.

As organizations look to bolster their prevention, detection, and monitoring capabilities, many are exploring how AI technologies can assist them in meeting regulatory expectations. Cognitive analytics can be used to help identify not just a single instance of conduct risk, but rather groups of behavioral risks. Understanding trends in conduct data and assessing anomalies can help an organization identify potential risk within their organization.

Organizations should develop a meaningful framework of sustainable change to:

• Understand the conduct risk across the entire organization
• Assess the controls framework to identify vulnerabilities
• Establish governance for conduct across the three lines of defense
• Consider how AI can support the framework

The global regulatory focus on market misconduct is evolving. FIs are increasingly expected to demonstrate how they manage market abuse and misconduct. Designing the right conduct risk program requires support from the business, technology, and regulatory experts. Driving alignment between these stakeholders is essential to inspiring trust, confidence, and securing accountability. Interested in learning more? Contact Jay McMahan to discuss.