July-August 2014

REGULATION: The all-seeing electronic eye

SatelliteMarket surveillance of fund managers and traders has increased since 2007. Nicholas Pratt looks at how the UK regulator is evolving its budget and skills.  In June, Martin Wheatley, the chief executive of the Financial Conduct Authority (FCA), the UK watchdog formerly known as the Financial Services Authority, spoke about the technology challenge in regulating the financial services industry. He referred to the pace and volume of technology-led change in the financial markets, typified by high frequency trading and the sudden escalation of technology risk (it now ranks fourth on the list of senior executives’ operational risk concerns after being as low as 18th just two years ago). Wheatley conceded that the regulator has often been slow to react to technological change in the past and should be “fleet-footed enough to support progress”. He added that it is “too easy to claim that regulation is always to blame when creativity or innovation slows in financial services”. Wheatley also when on to say that the FCA needs to improve at working harder at “looking for areas where the system itself needs to adapt to new technology or broader change – rather than the other
way round”.  Data and computers are playing an increasing role in the FCA’s authorisation, policy, supervision and enforcement work, he says, creating an overhaul of the FCA’s IT infrastructure. “We are currently working, as an example, on individual projects using computer networks with hundreds of gigabytes of RAM – and hundreds of computing cores, capable, in turn, of crunching many millions of data entries per second, enabling us to run through significant amounts of sophisticated econometric modelling in previously impossible ways. “Likewise, in the wholesale space, the FCA now employs gifted quantitative analysts and technologists, with expertise in areas like maths and statistics, to spot unusual trading patterns in the mountains of so-called ‘blue-sheet’ data we collect every day.  “Some 2.7 billion detailed transaction reports are processed through our analytics servers every year, as well as our surveillance software from Nasdaq OMX,” he adds. And to underline the impact of the enhanced IT infrastructure, Wheatley cited one important statistic: prior to 2008, the FCA had never criminally prosecuted insider dealing; it has since secured 28 convictions. BIGGER BUDGETS
Research from Kinetic Partners shows that the FCA’s overall expenditure between 2007 and 2013 has increased by 48%.  Given that the FCA has requested a £14.3 million (€18 billion) increase in funding for 2014 (from £432.1 million to £446.4 million), the budget increases look set to continue.  Nor is the FCA alone in seeking bigger budgets. In April 2014, the Commodity Futures Trading Commission (CFTC) in the US requested a 52% hike in funding to $315 million (€231 million), a third of which would be spent on IT. The CFTC commissioner and head of its technical advisory committee, Scott O’Malia, conceded that the requested increase was “improbable and unsustainable” but he did emphasise the importance of IT investment and called for a five-year technology investment plan.  “Execution in today’s market is done electronically,” said O’Malia. “If the commission is going to keep pace with growth and technological innovation in these markets, it must make automated surveillance the foundation of its oversight and compliance programme,” he adds.  Meanwhile the Securities and Exchanges Commission is seeking a 27% increase in budget, a sizeable proportion of which will presumably be spent on technology if the words of chairwoman Mary White are anything to go by: “In this rapidly changing environment, we must stay on top of advances in technology.” MARKET SURVEILLANCE
Market surveillance is a key focus for the FCA, including the trading activity of fund managers and other buy-side institutions, and is one of the areas where the increased expenditure has been most concentrated. In terms of technology, the FCA has not only developed its own in-house surveillance and monitoring system called Zen, it has also supplemented this with software from the third-party vendor market, such as the Smarts technology developed by Nasdaq OMX for real-time monitoring.  The strategy of retaining in-house development teams for developing the core platform and then buying software from the third-party market for real-time monitoring is one that more regulators should follow, says Monique Melis, former head of the transaction monitoring unit in the markets and exchanges division of the then FSA and currently global regulatory consulting lead at Kinetic Partners. “The combination of using real-time monitoring while having access to all transaction data on T+1, including client references, is a powerful one.” “These enhancements have been twenty years in the making,” adds Melis.  There was a lack of will, politically or otherwise, to seriously pursue instances of market abuse. And it was not until the onset of the financial crisis in 2007 that meaningful prosecutions were made in this area by the predecessor to the FCA.  This is not to say that the regulator was simply idle prior to 2007. In 1996 it established the Transaction Monitoring Regime, which collected all data in debt and equity, both on-exchange and off it. This included derivatives trading. “That is one thing we did get right,” says Melis. “It was a significant investment but it is starting to pay-off.” In addition to the increased IT expenditure, the FSA has also invested in recruitment, not only growing its headcount by 53% from 2,606 employees in 2007 to 3,992 by 2013, but also adding senior appointments from high-profile city roles, most notably the London Stock Exchange’s former head of regulation, Nick Bayley, as head of wholesale enforcement. Given the previous trend for regulatory heads to then take up senior appointments at investment banks (the FCA’s head of asset management supervision Ed Harley quit in November 2013 to take up a role as vice president of compliance at Goldman Sachs Asset Management), this is a welcome trend and one that sends a serious message to the industry, says Melis. “It shows that the FCA is committed to ensuring the skills that it has in-house match the cutting edge developments in the industry, ” she says. In addition to Bayley’s appointment the FCA has also hired a number of ex-traders as it tries to build skills in certain areas and overhaul not just who it recruits but how, says Aron Brown, managing director at consultant Newgate Compliance and also a former regulator with the FCA. The impact of the recruitment will not be felt too much in terms of the day to day running of the compliance function. The influence of the newly recruited specialists will be more behind the scenes, says Brown.  He also refers to the use of so-called “grey panthers” who previously held senior jobs in the industry and are able to bring their experience and views on how they believe regulation should be implemented. SOCIALLY USEFUL BANKER
“The grey panthers will always have a role. If they are there, they should be used because their experience is invaluable,” says Brown. But since 2008, there is much greater emphasis on technical specialists in specific areas able to advise front-line staff on how to engage with the firms they regulate. So how did the FCA manage to persuade so many traders to join its ranks?  It is untrue, says Melis, that everyone in the City is motivated solely by remuneration. While trading is exciting and highly competitive, working for the regulator offers other benefits including a career path, more long-term job security and an academic and intellectually challenging environment.  And while remuneration has been increased in certain areas in order to recruit, there is also a new level of credibility in working with the regulator that helps to attract the right candidates, says Brown.   The FCA is also expecting asset managers to increase their own IT expenditure, confirms Melis, in particular it is applying more pressure on buy-side firms so that they are forced into supplying more information electronically rather than manually.  “The sell-side is better at this than the buy-side which is still lagging in terms of automation rates even though the FCA sees them as systematically important as sell-side firms.” But while there has been a clear enhancement in the surveillance process, the frailties in the FCA’s enforcement are all too human judging by the feedback from the industry, says Melis.  “It is the industry view that when firms self-report, the penalties should not be too punitive or else this will discourage reporting.” The enforcement process is also inconsistent, depending on who is leading the case, and takes too long to process, says Melis.  “The longer the process takes, the worse it can be for those involved – it leads to good people leaving, disruption in the business, uncertainty for those not tarnished with the potential enforcement outcome, reputational risk and a lot of money spent on legal advice and service providers alike.  Some reflection and self-assessment by the regulator in this regard would be welcomed by the industry at large.” ©2014 funds europe

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