7.1: Everyone needs a surveillance model

As buy side firms face an increasing regulatory burden, an effective surveillance operating model has become a necessity, even for firms that believe the risks they pose might not justify it. 

Asset managers, hedge funds and wealth management firms are becoming subject to a growing roll call of regulations, such as MAR, MiFID, Dodd-Frank and – from the end of 2019 – SM&CR, which oblige them to put in place more robust compliance frameworks, including properly calibrated and more integrated surveillance to detect and prevent market manipulation, conflicts of interest and insider trading in real time. 

Regulators have meanwhile invested heavily in technology to improve their oversight capabilities, raising expectations for all market participants to do the same, and have hit buy side firms with a number of investigations and fines related to surveillance failings. 

But what is needed?
In many ways, the scrutiny is justified. As the electronification of markets gains pace and some buy side firms adopt more complex or algorithm-driven trading strategies across a greater number of asset classes and jurisdictions, compliance risk has grown faster than some have been able to keep up with. 

And while buy side players are showing strong willing to beef up their monitoring and invest in the necessary tech, there remains some confusion – especially among smaller outfits with relatively vanilla activities – about what kind of surveillance capabilities they need, and how much is enough.

The initial step for any buy side firm looking to build out their surveillance capability is therefore to take a detailed look at their activities, starting with the types of businesses they’re in. For example, the risk of insider trading can be amplified for discretionary hedge funds. Trade and communications surveillance must therefore be sufficiently integrated to detect intent, and such firms should consider incorporating behaviour analytics to gain a better understanding of any changes in behaviour. 

Asset managers also need controls in place to spot if traders or portfolio managers seek to manipulate markets with misleading information. Partly because of their advisory role, they must additionally be rigorous about adhering to regulations in every jurisdiction in which they operate, seeking therefore to implement surveillance systems globally that satisfy the rules of the most onerous regulator.

Wealth managers require an additional layer of controls in terms of monitoring their clients’ behaviour and risk profile, and ensuring representatives are acting in clients’ best interests.

As individual as you
Even within these groups, firms’ specific risks will vary widely depending on everything from their size and location to their trading strategy and practice, and these should be reflected in the surveillance operations, which will typically need to be more powerful and sophisticated the bigger and more complex a firm is. 

For example, a firm with an active trading strategy will need to monitor a far greater volume of trades and order types than a long-term buy and hold player. To establish intent, they also need to be able to analyse not just trade executions but order cancellations and corrections. Buy side firms that trade across asset classes will need to make the connection between alerts that are generated across all their activities and risk positions, plus related financial products. 

Participants that engage in algorithmic and high-frequency trading also need to match this with algorithms that can detect if an algo goes ‘rogue’, and whether it is simply responding to the market or manipulating it.

Regulators have indeed expressed particular concern about algorithmic trading and the risks it generates. The UK’s Financial Conduct Authority takes a view that any manager of a collective investment that engages in algorithmic trading is subject to MiFID II’s organisational requirements for algorithmic trading firms. They should therefore maintain an inventory of all algorithms used, including how they work and what risk controls are in place for each. All staff involved in the development and surveillance of algorithms should also receive market abuse training.

Time to design
Before buy side firms get to the point of choosing a surveillance solution, many need support with market data, given the vast number of instruments and markets they participate in. One of the biggest challenges reported by buy side firms is working out how to structure data and get it into formats they can use for surveillance tools.

Once this work is under way, firms have more choice than ever in terms of surveillance solutions as a growing number of vendors seek to cater to the buy side’s unique risk profile. 

Whether they choose to buy or build – the latter of which is more viable for larger outfits with strong tech support – their chosen solution should integrate as much as possible any trade and communications surveillance. They should incorporate numerous detection scenarios across various business lines, asset classes and jurisdictions, and feature a case management tool that enables firms to manage alerts efficiently and produce audit trails. 

Solutions should also allow firms to decide whether or not to store data onsite or in the cloud, depending on their budget and IT support. For more sophisticated firms, a behavioural analytics capability – integrated into the solution – will add further value. 

Choosing a surveillance solution is, however, only the beginning of the journey. Once a firm has the necessary 360-degree view of its risk, this will inform what additional functionality it needs to buy or build in the future, ensuring its surveillance capabilities also grow and change shape as its risk profile evolves.

Based on an international benchmarking survey collecting the views of industry leading experts from 15 of the largest financial institutions globally, the 2020 Surveillance Benchmark Report provides a unique insight into the maturity and development of surveillance functions over the last 12 months, as well as predictions for the future. Including in-depth commentary from regulators, practitioners, consultants and technology experts, it is the only report for professionals in the industry.

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