Technology as a Transformative Regulatory Force
In the global financial services industry, new technology is driving a “transformational” change as Martin Wheatley, CEO of the FCA, put it earlier this year. Whether it’s mobile banking, high frequency trading (HFT), payments technology, portfolio analysis or big data, all the main drivers behind industry change are technology-led.
This trend certainly presents market participants with both opportunities and challenges. Whilst for many, these developments open important new opportunities, Mr Wheatley also noted that for others “the skies are darker”.
“The concern here is that financial services will become a kind of tech-led Wild West, if you like – full of cybercrime, data losses, runaway algos, flash crashes and hash-crashes of the type we saw last year, when hackers took over the twitter feed of AP [Associated Press].”
On the other side of the Atlantic, US regulators are all too familiar with these difficulties. In fact, as our recent Global Enforcement Review (GER) reveals, technology is also transforming the way regulators monitor and control the industry.
Nick
Published in April, our GER report found that from 2006 to 2013, the SEC increased the number of employees by approximately 22%, but overall expenditure by 62%. For Hong Kong’s SFC, the increases were 51% and 120% in the same period.
Regulatory Spending Shifts to Technology
If not on headcount, where is the extra money going? It is technology, rather than headcount, that accounts for this extra expenditure by regulators.
As SEC chairwoman Mary Jo White observed earlier this year: “It is not only our job to keep pace with this rapidly changing environment, but, where possible, also to harness and leverage advances in technology to better carry out our mission”.
Likewise, while expenditure increases have trailed the rise in headcount at the FCA, creating advanced Information Systems (IS) has been a primary objective, as stated in the regulator’s 2014/15 Business Plan.
Building Regulatory Capability Through Surveillance
Increased surveillance
Our research showed that in the US for 2013, nearly a quarter (24%) of all actions were enforcement actions over insider trading, market manipulation, financial fraud, issuer disclosure and similar activities. Meanwhile, in Hong Kong and the UK, insider dealing and market manipulation accounted for the lion’s share of the total value of fines against individuals. They were the primary causes of enforcement actions in Hong Kong, and second largest in the UK. Across the world, regulators are meticulously focussed on ensuring clean, fair and orderly markets.
Significant investment in technology, by regulators and firms alike, is the inevitable consequence of the regulators’ focus on market abuse.
Technology is central to detecting this abuse and developing cases against wrongdoers. This is perhaps most obvious when it comes to high frequency and algorithmic trading. Regulations, such as the EU’s revised Markets in Financial Instruments Directive (MiFID), may impose restrictions on the usage of high-tech transaction tools, but enforcement will depend on systems like the US’s National Exam Analytics Tool (NEAT) and Market Information Data Analytics System (MIDAS) or the UK’s ZEN database.
By capturing and analysing millions of transactions a day, these surveillance technologies improve the capacity of regulators to detect insider trading, front running, market manipulation and other forms of misconduct. These investments are also, in a sense, pooled: increasing cross-border cooperation. This has been demonstrated in recent market abuse cases around Libor and Forex rigging and illustrates that regulators are willing, and able, to share data to identify abuse. Creating clear channels for exchange of information across jurisdictions and with law enforcement agencies has been a significant accomplishment in global regulators’ investigative and prosecutorial procedures.
Industry Responsibilities and Reporting Demands
Nevertheless, it is not just regulators who must bear the burden of facing up to new technological challenges. The financial services industry itself must play its part and the regulators have made this clear.
Protecting itself
Regulations such as MiFID and European Market Infrastructure Regulations (EMIR) already point to a greater need in terms of transaction reporting requirements from regulated firms and also non-financial counterparties. As technology enables regulators to more easily “crunch data”, the demand to supply it also grows. The growing capabilities of the regulators will also mean greater scrutiny of the data being supplied. There will be greater pressure from regulators for firms to produce accurate and timely data in the correct form.
As noted in the GER report, firms will be expected to police themselves and demonstrate that they are maintaining strong cultures and systems to detect and discourage misconduct. Manual, sample-based approaches to monitoring and even the continuing use of spread sheets in some firms will give way to more sophisticated and automated systems that capture and analyse entire sets of data. There is simply no other way to monitor transactions effectively and guard against abuse, even for firms executing only a modest number of trades.
With the advent of MiFIR and MAR, for firms other than large sell-side investment banks – from which regulators have long required detailed transaction monitoring and reporting – this will continue to present challenges. Theoretically at least, those banks already have significant internal monitoring and reporting capabilities in place; in Kinetic Partners’ experience, many buy side-firms do not.
Updating technology and capacity will require investments of time and money, and considerable support from advisors. However, regardless of what regulators require, it is in the interest of businesses to embrace new technologies.
Individual Accountability in Regulatory Enforcement
Regulators have emphasised that ultimate responsibility properly lies with individuals, rather than the firm. It is individuals who are increasingly the focus of sanctions. Even the SEC, which has historically been more focussed on actions against individuals than some other regulators, remains keen to stress its continued commitment to pursuing those individuals who are accountable.
Regulators are significantly more likely to look positively on firms which have established robust systems to detect and report abuse themselves, or at least demonstrated a proactive commitment. However, with the increased technological complexity of markets, and enhanced regulatory surveillance capabilities, firms and individuals judged to have contributed to, rather than curtailed, the Wild West, will be ever more likely to find themselves in the regulatory cross-hairs.
