An Ounce of Prevention and a Pound of Cure: The Importance of Monitoring for Manipulative Trading
For all broker dealers, the importance of installing a market surveillance system can’t be understated. The capital markets’ main governing bodies, the SEC and FINRA, have put a great deal of responsibility on individual firms to maintain a level playing field. Failure to supervise trading activity or report exceptions can lead to lengthy, expensive audits, massive fines and reputational damage.
Fortunately, as regulatory requirements have expanded, the technology to meet those stringent standards has improved and become more affordable and more automated. Thin, unobtrusive SaaS applications offer a great deal of protection from compliance penalties for minimal investment.
The Proposed Consolidated Audit Trail
Immediately following the Flash Crash of May 2010, the SEC proposed the development of a “Consolidated Audit Trail” (CAT) that would monitor and analyze all trading activity across markets. At the end of June, the SEC will accept proposals from organizations including FINRA and potentially Google, detailing how such a system could be built, scaled and operated.
The SEC’s push for an over-arching database that would track and trace all broker dealer activity is a clear indicator of where the regulatory environment is headed. Rather than taking the monitoring burden off of broker dealers, a consolidated audit trail would force firms to be more vigilant of their own activity in order to prevent scrutiny from the governing bodies’ more watchful eyes.
Rising Scrutiny Around Broker Dealers
As the CAT plans show, regulators are increasingly inspecting trade activity and supervision of broker-dealers. The SEC filed 134 enforcement actions related to broker-dealers for the fiscal year ending 2012, a 19 percent increase over the previous year, including charges against a Latvian trader and electronic trading firms for manipulating prices of over one hundred NYSE and Nasdaq securities in an online account intrusion scheme.
The SEC also charged a New York-based brokerage firm more than $5.9 million for manipulative trading activities, anti-money laundering and other violations. The firm, Hold Brothers On-Line Investment Services, allowed a significant volume of overseas day trading to pass through its systems on a regular basis without proper supervision.
Hold Brothers failed to establish and maintain a supervisory system and written procedures for supervising its trade activities. FINRA found that “red flags” for suspicious trading were not detected or investigated. Further, there were numerous instances when their compliance department indeed detected suspicious or manipulative trading, but neither escalated it to the firm’s AML compliance officer nor filed a suspicious activity report.
A formal system to capture suspicious trading activity would have given Hold Brothers leverage in arguing that the company did its best to supervise its clients’ activities.
The True Price of Automated Compliance and Reporting Tools
Manually supervising trade activity and adhering to compliance standards can be tedious and inefficient for broker dealers. Broker dealers who manually carry out compliance activities run the risk of making a careless mistake. Switching to automated compliance and surveillance tools decreases the likelihood of errors, benefitting both brokers and investors. More importantly, the cost of automating compliance activities pales in comparison to violation fines levied by the government – which can be a huge setback for broker dealers.
Automated compliance solutions give broker dealers instant access to trade exception dashboards, providing important electronic records of identified issues and the actions taken upon them. Since the SEC and FINRA often assume firms are “guilty until proven innocent,” in the unfortunate case that a broker-dealer is charged with “failure to supervise”, a compliance database may be needed on a moment’s notice to prove innocence, which would be impossible to prepare with manual processes alone.
Scalable, automated tools also allow broker-dealers to take on more business without sacrificing their surveillance requirements. Taking a proactive approach to compliance and regulatory reporting adds credibility and trust to a firm’s operations. Choosing to implement an automated compliance solution gives firms the ability to effectively monitor trading activity and to avoid expensive, career-damaging disciplinary action.