Market surveillance: Big Brother is watching you

Market surveillance: Big Brother is watching you

Market surveillance systems are the latest thing attracting the attention of chief technology officers at financial firms. And small wonder. Two years ago Société Générale was nearly laid low by Jérôme Kerviel’s unauthorised trades, and regulators in every major centre are clamping down on abusive trading.

Over the last year the UK’s Financial Services Authority has levied £83.9m of fines on companies for regulatory breaches. Not all of this is due to trading infractions, but when you consider that only £7.4m of fines were levied in 2002, the trend is clear.

Giles Nelson, deputy chief technology officer at Progress Software (pictured), points to the financial crisis and the flash crash as two reasons for the keen focus on trading risks. “Regulators are baring their teeth a bit more,” he says. “For example, the FSA has informed brokers in the UK, you need to start showing us your internal processes to ensure that you know what is going on – you can observe your own order flow, your prop flow but also the flow coming in for your clients as well and you need to show us what you have in place to do that. The regulators are becoming a bit more aggressive.”  

In Germany, too, there is a growing market for surveillance systems according to Wolfgang Fabisch, CEO of b-next, which supplies monitoring technology to the regulator, Bafin.

In fact, technology vendors have seen the demand for market surveillance and supervision systems mushroom, all over the world. A clear signal of this is the pace of dealmaking in the sector. Nasdaq OMX, for example, agreed in July to buy Smarts, the Australian market surveillance software specialist.

The purpose of a market surveillance system is to detect market manipulation, insider dealing, fraudulent or unauthorised trading, and other offences, which may be punishable by fines, imprisonment or bans from the market.

The job gets harder

Far from such abuses becoming less of a problem as markets develop, the policing job is getting much bigger and more difficult.

As Rik Turner, senior analyst at research consultancy Ovum in London, points out, one of the main drivers in the evolution of technology is “to do more in less time”. More good – but potentially also more evil.

“Market surveillance has to keep up with faster matching engines and greater order volumes,” Turner explains. “With matching engines forging ahead in reducing their latency and upping their throughput capabilities, market surveillance systems face the challenge of keeping up and correlating information across multiple assets and potentially from multiple venues to detect suspicious activity.”

And not only does faster trading make it harder to spot abuses – it also creates conditions where new kinds of shady trading can occur. The rise of high frequency trading (HFT) is changing markets in ways that honest commentators have to admit they only barely understand.

Bart Chilton, commissioner at the US Commodity Futures Trading Commission, called in a September article for regulators around the world to develop new rules to curb the influence of HFT firms in any subsequent market crash (see page 10).

He stressed that in the past, regulators did not have the technological ability to keep up with algorithmic traders, but said that now had to change.

Techniques catch on

Fortunately, it is already changing. Graham Jordi (pictured), executive general manager of Smarts in Sydney, says that regulations vary greatly from country to country, but that exchanges have the choice whether or not to use a surveillance system.  

More and more exchanges are opting to do so – and many are upgrading their existing systems and bringing technology in house.

Jordi says one of the main reasons why Nasdaq OMX bought his company is that its technology complements the exchange’s. Such deals by exchanges are a logical move, adds Jordi.

The company's two main products are Smarts Onsite and Smarts Online, as well as Smarts Broker, used by over 50 brokers internationally.

The Australian Securities and Investment Commission implemented a Smarts market surveillance system earlier this year, and in June the Intercontinental Exchange made the same choice, becoming the firm’s biggest derivatives exchange customer.

Ice is using the Smarts Integrity Platform alongside its own existing market monitoring activities, across its futures exchanges.

Jordi gives three reasons why the demand for market surveillance systems has grown. “Volume is one of the key factors,” he says. “As more and more electronic trading takes place, it gets harder and harder to use other mechanisms to keep track of what is going on. Complexity is another factor, and understanding the role of surveillance. When we started out in the ’90s there were a few takers. Largely the view was, with exchanges and regulators – this is not really necessary. With time and the occasional crisis or crash, there has been more attention.”

One way in which understanding has broadened, Jordi argues, is that exchanges have come to realise surveillance technology can be deployed not just to meet compliance obligations but also to serve other internal business needs.

Market replay

An emerging player in this field is the Sri Lanka-headquartered technology vendor, MillenniumIT, recently bought by the London Stock Exchange.

MillenniumIT’s surveillance system is used by a derivatives exchange in India, the Indian Commodity Exchange, and it has struck a deal with the Egyptian Stock Exchange, which is installing the trading surveillance system.

Fuard Ahamed, vice-president of product management for surveillance at MillenniumIT in Sri Lanka, says: “We will complete the deployment at the Egyptian Stock Exchange and the Securities and Exchange Commission of Sri Lanka by October this year and a new commodity derivatives exchange in India by December this year.”

MillenniumIT’s system seeks out manipulative trading behaviour in real time. Through the company’s Business Innovation Dynamically technology, Ahamed explains, users can modify or create additional alerts to extend the system with minimal assistance from MillenniumIT.

The system’s latest offering includes a ‘market replay’ component, allowing investigators to go back in time to reconstruct trading events as they occurred.

End-to-end solution

An experienced surveillance supplier is Massachusetts-based Progress Software, which provides the system used by the UK Financial Services Authority.

Progress’s Giles Nelson confirms that appetite for such systems has increased rapidly in the past few years.

The market surveillance technology Progress offers is built on its Apama offering. “The new release is an evolution of that system,” says Nelson. “We are calling this ‘responsive process management’. As well as being able to spot the market abuse types such as front running, you can then do case management as well.”

Progress’s system is designed to help firms spot market abuse types, handle each case, document it all and track how the process is operating.

Never stand still

The importance of market surveillance is highlighted by the attention it is getting from big, diversified software companies such as 3i Infotech.

“Market surveillance has become one of the primary drivers for you to expand your market, especially in the emerging markets,” says Bharat SV, who heads business development for western Europe at 3i Infotech in London.

But 3i Infotech is no newcomer to the product. Back in the 1990s, one of its earlier customers was the Bombay Stock Exchange, which later white-labelled the technology.

The Indian regulators, Bharat recalls, had come up with very strict requirements so there was a need for a very flexible and powerful transaction monitoring tool. That was the birth of the company’s system AWCS.

That need to be responsive to regulators’ specific needs – which may change rapidly – is as important today as ever, Bharat emphasises.

“You would have to be absolutely to the minute in terms of meeting the regulatory requirements – otherwise the regulator would not give you additional positions to launch new products,” he says.

Such responsiveness may be one reason why 3i Infotech’s system recently went live at the Zagreb Stock Exchange.

Another Balkan exchange, that of Athens, is said to have shortlisted Smarts, but is still considering building a system in house.

Little by little, surveillance systems are covering the world’s markets.