Regulators’ Focus on Primary Market Abuse Calls for Investment Banks to Fortify Trade Surveillance

Regulatory actions are pointing towards a high stakes form of capital market manipulation, primary market abuse. Regulators are keen to curb traders’ practice of manipulating prices to create additional profits around corporate new issues. The CFTC recently
penalized HSBC $45M for just this thing – citing the manipulation of bond issuer swaps. Based on the regulator patterns in this category, it is clear that primary market manipulation – or Reference Price Transaction (RPT) manipulation – can result in enormous
enforcement penalties, widespread reputational damage to an institution, and increasingly, personal liability to senior managers or traders involved. Investment banks must reinforce trade surveillance methods to successfully monitor sophisticated forms of
criminal activity and stay in compliance with strict regulatory scrutiny. Compliance officers and risk and control officers now are compelled to take responsibility for capturing any abusive behaviors in RPT.

Challenge of primary markets abuse

When shares or bonds are first sold to the public markets, the issuer will often simultaneously enter into other trades, such as bespoke interest rate swaps or structured foreign exchange (FX) trades, with the bank leading the transaction. However, that
bank’s traders may be manipulating prices in the public markets to create additional profit when they enter into these primary market derivatives with their client. Because it often involves very large notionals and abuse of a privileged position of trust,

primary market abuse comes with different ramifications than secondary market abuse. The danger is that a single trader or a small group of traders act independently to pad out the profits of their trading books regarding the associated RPTS, and by doing
so undermine the larger corporate advisory and associated ECM / DCM business that are driving the deal.

What regulators want

In many investment banks, RPT is monitored on a random selection basis. Regulators say this is quite insufficient. FINRA also warned that institutions do not have “procedures reasonably designed to identify patterns of manipulative conduct.” So, the message
is clear, the status quo of surveillance is no longer sufficient or acceptable in relation to surveillance of the rapidly evolving primary markets sector.

Determining the intent of the trader

The CFTC has an ongoing case against a managing director at Nomura for primary market manipulation – also in bond issuer swaps. In order to detect such price fixing activity, surveillance officers face a challenging two-prong mandate. First, they need to
determine and quantify whether the trader’s activity has affected the market and corresponding execution price of the customer order. Secondly, they need to establish whether the trader acted in a premeditated way to commit market manipulation. Complicating
matters, it’s sometimes difficult to delineate between legitimate trading activity like disclosed pre-hedging and the artificial manipulation of prices. The CFTC requires that swap dealers like Nomura must disclose any pre-hedging to customers, to allow a
counterparty to assess the material incentives and conflicts of interest. Moreover, institutions must

“establish and maintain a system to supervise, and shall diligently supervise, all activities.”

Trade surveillance technology, with a trading desk mindset

For banking compliance leaders and surveillance teams, the key to efficient oversight is implementing processes that can accurately determine the market participant’s intention to game the market, prioritize higher value alerts, and detect hard-to-find,
cross-product manipulative activity that poses the biggest regulatory and financial risks. Current trade surveillance practices are truly
a sun revolving around the earth approach, from a single venue, overly complex rules-based perspective. A more sensible trade surveillance approach recognizes the earth traveling around the sun, a simpler and more sustainable solution that makes observations
through the lens of market risk.

The cunning sophistication of these cross-product, RPT abuses demands that investment banks develop a better understanding of the relationships between instruments and find technology that can best determine the trader’s intention so they can accurately
measure the market impact of any given position.

Today’s enormously complex financial markets have led to more complex forms of abuse, and trade surveillance methodologies are struggling to match bad actors’ ingenuity. Primary market abuse — abuse arising from large OTC transactions associated with primary
markets — is a blind spot that trade surveillance mechanisms must illuminate if banks are to ensure the highest risk cases can be investigated first, and ultimately identify abusive behavior before the regulators.

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• Source: https://www.finextra.com/blogposting/25982/regulators-focus-on-primary-market-abuse-calls-for-investment-banks-to-fortify-trade-surveillance?utm_medium=rssfinextra&utm_source=finextrablogs