FCA Market Watch 69

The FCA has just published its latest Market Watch 69. This, like earlier editions, includes important findings which firms are well-advised to take into account in assessing the adequacy of their own processes, procedures and controls. They also give a strong pointer to where the FCA has found deficiencies which may well be the subject of future enforcement action. In addition, where firms are found to not to have paid sufficient attention to the FCA's warnings and fail to meet those standards, the Market Watch may well become a "stick to beat them with".

Market abuse risk assessments

The FCA has previously discussed the benefits of a comprehensive, accurate and up-to-date market abuse risk assessment and how it can help ensure effective surveillance coverage. This is a key document for firms to have in place and keep up to date, ensuring that it is tailored to their own activities and the risks faced.  The most effective assessments involve consideration of each of the different types of market abuse and how they apply across each area of the business, and in relation to each asset class.

Identified failings/weaknesses

• Some firms assess only insider dealing and market manipulation at a high level of generality, without considering how different levels of risk might apply to different sub-categories of these, such as layering and spoofing, wash trading and ramping.
• Similarly, some firms whose business involves activity across a range of asset classes fail to distinguish between them when assessing for risk.
• Others do not consider how different types of business activity, such as discretionary vs. execution-only, or client vs. house trading, might present different market abuse risks. Some firms do not consider the method of execution (e.g. electronic vs. voice-broked markets) or the nature of the platform where the trading takes place (e.g. lit vs. dark books, central limit order book vs. auction).
• Some firms completely discount the risks in certain business areas because of low trading volumes, without considering the inherent risks.

Order and trade surveillance

While FCA notes that surveillance arrangements are improving across the industry, there continues to be significant variance in approach.  While the FCA has seen examples of comprehensive, tailored systems, accurately aligned to risk assessments, it has identified a range of failings and weaknesses in the approach taken by other firms.

Idenfitied failings/weaknesses

• FCA sees instances of little or no monitoring taking place.
• While some firms consider the different characteristics of different asset classes and instruments before applying this information to calibrating alert scenarios, others applied generic calibration across (and within) asset classes, where the nature and scale of the metrics involved (e.g. price movement)were significantly different e.g. 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 worth review, the size of the move is usually quite different.
• While third-party system functionality in areas such as tailored calibration has progressed in recent years, sometimes firms are unaware of these developments and so may not be making 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.
• Some firms identified insider dealing as a key risk and monitor for it but inhibit the surveillance system's effectiveness by applying inappropriate thresholds to calibration. The most significant example involves 'lookback periods' for insider dealing – e.g. 24 hours before the release of inside information is in the FCA's view not enough for the purpose of detecting suspicious trading in advance of an announcement. The FCA did not, however, provide guidance on how much further back firms should be looking back.
• Some firms were not monitoring all orders and trades, including cancelled and amended orders - the surveillance of orders, particularly those that do not result in a trade, can be critical.
• Some firms had weaknesses in their review of surveillance exception alerts. For example, only escalating and considering reporting where they identify an obvious link between the client and the issuer or source of the inside information.

Enforcement risk

As noted above, firms need to be aware of the risk of Enforcement action in relation to surveillance for market abuse.  While a great deal of judgment will be required in setting the parameters for automated trade surveillance systems, which can be more difficult for the FCA to criticise, the real risk for firms is threefold.  First, the firm will be vulnerable to FCA action where it has not conducted a tailored market abuse risk assessment that properly identifies and seeks to detect the specific risks that the business faces in relation to each of its activities and asset classes.  Second, the FCA may target the firm where it cannot provide a clear rationale for the parameters that have been applied for the purpose of identifying suspicious trading activity in relation to each type of scenario.  Finally, the failure of a firm to review each of the hits from the automated system on a timely basis for the purpose of identifying whether problematic behaviour has actually occurred will also be a significant red flag for the regulators.  

Other issues considered include:

1. policies and procedures;
2. outsourcing;
3. front office involvement;
4. countering the risk of market abuse-related financial crime; and
5. investigations into potential market abuse by firms' employees.

Authors: David Capps and Nathan Willmott