Holistic conduct risk management for dealing room controls
Fair play in the securities market key to balancing supply-and-demand dynamics
Authors:
Bimal Modi: Partner, Deloitte Touche Tohmatsu India LLP
Soniya Mahajan: Director, Deloitte Touche Tohmatsu India LLP
Performance Magazine Issue 44 - Article 3
To the point
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The increase in high-profile front running, insider trading and other market abuse cases by financial services professionals has raised serious concerns for regulators and the market’s institutions alike. Misusing privileged information of institutions’ big orders is not only unethical on the part of the employee; it also has a high probability of deceiving unwary investors and impacting markets at large.
For example, in the case of a front-running scheme, orders placed by front runners (either by the employee themselves or to whom this privileged information was shared) may trigger artificial supply and demand in the market. This impacts the investors’ sentiments, as they may follow the buy/sell market trend and end up losing out after the stock prices are corrected upon the big order’s execution.
As a result, front-running schemes are not just limited to illegal gains by the front runner, but also pose operational, reputational and regulatory risks to the institution and damage regulators’ and institutions’ efforts to protect investors’ interests.
Given the growing regulatory focus, institutions are seeking a proactive methodology to monitor investment professionals’ conduct and prevent potential unethical practices.
Market abuse cases on the rise
Amid the growing number of market abuses, several high-profile cases stand out. On 27 April 2023, India’s securities market regulator raised an interim order against the country’s largest life insurance undertaking, which debarred suspected individuals and entities from securities market trading, froze bank accounts and impounded wrongful gains amounting to INR2.44 crores.1 One of the company’s investment professionals was alleged to have misused information regarding large buy or sell orders for personal gain, impacting supply-and-demand dynamics and manipulating the trading price in the front-runner’s favor.
In another front-running case in February 2023, India’s securities market regulator debarred around 21 entities, and impounded INR30.55 crores gained from a front-running scheme run by a fund manager of a large asset management company.2
These front-running schemes are witnessed across the globe. For example, a recent order was issued by the US Securities and Exchange Commission (SEC) for multi-year front-running schemes by employees of major asset management firms and investment banks, with one institution penalized USD249.4 million in a recent case.3
These cases of foul play and privileged information misuse are highly unethical and are likely to deceive investors and impact markets at large. For example, orders placed by front runners trigger artificial supply and demand in the market, manipulating unwary investors and leaving them feeling cheated.
Current anti-market abuse processes
To comply with regulatory requirements, institutions have defined and identified individuals who handle price-sensitive or privileged information. Many organizations have also implemented rigorous controls for monitoring trades in these identified individuals’ trading accounts, and even their immediate relatives’ accounts, by requiring them to pre-clear their trades with compliance officers and promptly disclose trades in their personal accounts to the organization.
Several jurisdictions, including India, mandate that the conversations of fund managers and dealers are recorded during market hours to detect the disclosure of privileged information. Some institutions have gone further and set up dedicated and secured dealing rooms for equity and fixed income, access-controlled dealing rooms, and restrictions on carrying and using personal phones inside dealing rooms and during market hours. Some have also installed video cameras inside dealing rooms to monitor and detect unauthorized access and abnormal activities.
In addition to these controls, investment back-office or compliance teams perform periodic reviews to identify trades with distorted volume weighted average prices (VWAPs), especially significant market trades that are susceptible to front-running schemes.
However, despite all these efforts, some institutions are still failing to prevent and detect unethical conduct by investment professionals, and are struggling to demonstrate their implemented controls to regulators.
Holistic conduct risk management frameworks
The reason for these challenges may lie in institutions’ fragmented approach and insufficient use of technology, which monitor individuals’ trading accounts, the institution’s accounts and calls in isolation. Consequently, institutions are moving from reactive analysis to proactive, holistic monitoring through designing conduct risk management frameworks.
These frameworks consist of four primary pillars:
- Clearly defined policy and processes;
- People with appropriate skill sets;
- Tools and technology to aid the institution’s prevention and detection strategy; and
- Governance to oversee the conduct risk management process.
While many institutions have the first two pillars in place, deploying the right tools and setting up governance will bolster their monitoring of dealing room transactions and behavioral patterns. Tech-enabled tools can perform a 360-degree assessment and identify abnormal patterns and red flags, including large trade data analytics platforms, voice analytics, data leakage prevention (DLP) systems, and electronically stored information (ESI) review platforms.
These tools can raise red flags by comparing identified personnel’s unusual trading patterns with the institution’s patterns, and comparing trade confirmations from brokers with the institution’s trade data. They can also profile behavioral patterns by analyzing big orders, call recordings, chats, business allocations to brokers, dealer commission concentrations, violations of roles and responsibilities, and dealing room access logs.
This technology-enabled framework can help institutions analyze this data in “near-real time”, providing an intelligent dashboard that summarizes outliers for compliance teams to investigate further. These outliers are based on various pre-defined scenarios around residual risks, identified through an iterative control risk assessment process.
Additionally, institutions may also consider using tools that perform social media and lifestyle checks on identified personnel to flag any undisclosed sources of income. These tools could also strengthen senior management’s governance and oversight by automating periodic management information system (MIS) reports.
Conclusion
The rise of front running, insider trading and other market abuse cases indicates that many institutions’ market controls are falling short. To mitigate operational, reputational and regulatory risk and create a fair marketplace for investors, financial services institutions should consider deploying a holistic conduct risk management framework for their dealing rooms.
Tech-enabled tools can help institutions implement strong and effective controls to proactively monitor the trades and behavioral patterns of dealing-room personnel. And given the dynamic nature of risks, a 360-degree periodic assessment can allow institutions to align their residual risks with the corresponding monitoring mechanisms.
These holistic monitoring systems will help deter unethical practices and streamline efforts to create a safe and fair marketplace for investors at large.
1Aathira Varier, "Front running case: LIC fires employee banned by Sebi from stock market," Business Standard, 20 March 2024.
2Palak Shah, "SEBI impounds ₹30.55-crore ill-gotten gains in Axis Mutual front-running case," The Hindu Business Line, 28 February 2023.
3KS Badri Narayanan, "SEC charges Morgan Stanley, Pawan Passi in front-running case," The Hindu Business Line, 12 January 2024.
