The Role of Real-Time Surveillance in a World of Slow Enforcement

BATS Trading is fed up of being spoofed. On 18 February 2016, the alternative US exchange operator founded in 2005 by high-frequency trading guru Dave Cummings, asked US market regulator the Securities and Exchange Commission (SEC) to shorten the time it takes to suspend trading accounts of firms engaged in ‘spoofing’ and ‘layering’ (for BATS Trading definitions see below) and other abuse. It effectively wants the power of arrest.

The request was made following feedback from market participants on its first request made in November 2015. It is necessary because exchanges often have to wait years to suspend the accounts of traders engaging in nefarious activities. The reason for that is historical – assuming innocence, a trial is needed to prove guilt. However in the modern age it is possible to witness and record a crime with real-time surveillance as easily as with CCTV.

“The problem is not the surveillance, I think the surveillance that is happening just fine, the answer is what do you do with the information you get out of surveillance,” says Michael Grecoff, head of sales for Scila Compliance at technology provider Cinnober.

The reason BATS feels the need to implement a faster account suspension is that the exchange believes “there are certain obvious and uncomplicated cases of disruptive and manipulative behaviour or cases where the potential harm to investors is so large that the exchange should have the authority to initiate an expedited suspension proceeding in order to stop the behaviour from continuing on the exchange”.

Frustratingly for the exchange, resolution can often take years, and that is a common problem according to several other market operators. BATS cites several examples including that of Navinder Singh Sarao, currently being extradited from the UK to the US for allegedly manipulative trading activity, which BATS notes “included forms of layering and spoofing in the futures markets”. According to the Chicago Mercantile Exchange he was warned about his behaviour dating back to 2010 and yet he was allowed to continue trading into 2014.

In cases where the trading party protests its innocence but is subsequently found guilty, other market participants will have had that firm rifling through their belongings for the period of the investigation, stealing their hard-earned profits.

Every breath you take

The length of this investigative process raises a serious question about the value of real-time market surveillance. It is apparent that many markets do not have the capacity to suspend trading accounts where they see abuse occurring even if the technology they have allows them to “to be identified in real-time or near real-time,” as BATS Trading notes.

In Europe, the London Stock Exchange Group has the capacity to suspend accounts almost immediately in the event that a member or their client is preventing an orderly market however spokesperson for the Exchange, Tom Gilbert, reports that such activity, “has never been seen; it is almost a philosophical position rather than a reality” and that taking away a firm’s capability to make money puts any exchange on “quite difficult legal ground”.

To ensure that its members and their clients are treated fairly the LSEG has due process involving a checklist to determine the scale of the problem, for example examining how many others are affected by the activity, triggering an investigation if a rule breach was found to have been made, after which a panel of the exchange’s own staff would then look at the decision and a separate disciplinary committee of non-exchange staff would be engaged. The appeals committee is equally made up of non-exchange staff.

At Deutsche Börse, account suspensions are also possible, but they are outside of the responsibility of Deutsche Börse as the operator of the Frankfurt Stock Exchange. “The institution responsible for suspensions of members and other penalties is the Sanctions Committee,” says Andreas Brevern, spokesperson for Deutsche Börse says, “This committee is not subject to any instructions from the exchange’s board of management. It is subject only to the supervision of the Securities and Exchange Commission of the State of Hesse. Its mission is to penalize infringements of exchange regulations of trading participants or issuers.”

The committee can impose fines of up to €250,000, or a suspension of a trading member for up to 30 trading days.

Grecoff says, “Some exchanges do monitor in real time, but will they pick up the phone and call up the trader causing these orders not to enter the market in real time? Likely not. There is drawn out process to investigate, making sure that there is a pattern and to make sure that there is the evidence to back up a claim.”

Every rule you break

This multi-layered structure of surveillance, supervision and enforcement is common across jurisdictions. In the US, BATS says it operates a “comprehensive regulatory program that includes automated surveillance of trading activity that is operated directly by exchange staff and by staff of the Financial Industry Regulatory Authority (FINRA)” a Wall Street funded private company that operates as a self-regulatory body.

The New York Stock Exchange (NYSE) and Nasdaq have both insourced market oversight functions since 2014 from FINRA, having previously outsourced them, claiming that they are more efficient at performing the oversight function themselves.

There are no independent figures to provide a comparison of the efficiency of enforcement that is delivered by independent oversight, set against oversight shared across a market operator and separate body. In most circumstances the capacity to warn off rogue traders is often enough argues Grecoff.

“When the trader receives a letter from a regulator that their orders and trades have been noticed – not that the trader is accused of anything – 90 per cent of the time you never see that activity happen again,” he says.

However in a world of digital real-time surveillance it appears that the capital markets are increasingly in need of a beat cop (as well as all of those lawyers).