Market Watch 73 puts spotlight back on CFD providers

The FCA’s latest Market Watch highlights areas for improvement in market abuse controls in CFD providers while recommending some best practices.

Market Watch 73, published at the end of April, reported the findings from the FCA’s recent market abuse peer review into firms that offer Contracts for Difference (CFDs) and spread bets (CFD providers). The review aimed to improve the FCA’s understanding of CFD providers’ arrangements to identify and report potential market abuse and raise standards.

The report acknowledges a variety of approaches to market abuse controls and shared some helpful recommendations.

Market abuse risk

When it comes to identifying and assessing market abuse risk, granularity is key.

The review highlights that the risk of market abuse could differ between and within asset classes depending on execution methods; as part of the risk assessment, due consideration should be given to market abuse risks for non-equity classes and market manipulation.

The review also makes clear that undertaking an assessment of your market abuse policies and procedures that is too general would not achieve this objective. Understanding how your firm could facilitate market abuse is a good starting point for designing and maintaining effective systems and controls. This is not only true in the CFD space, but is also applicable to other sectors across the industry.

Market abuse surveillance responsibilities

For market abuse surveillance to be useful and effective, there needs to be a degree of segregation of duty. There is an inherent conflict of interest in the front office handling surveillance of their own activities and effectively marking their own homework. The responsibility for market abuse surveillance should, therefore, sit with an independent compliance function.

For smaller firms where resourcing is constrained, alerts handling should, at the minimum, be overseen and quality assured independently.

Surveillance systems

Most firms the FCA visited could demonstrate their insider dealing alerts to be largely effective, however an area of concern identified was where firms didn’t monitor for unrealised profits, either specifically, or by capturing them via discrete alerts such as news or price movement, which operate independently of profit. You should also consider whether your surveillance coverage is adequate for market manipulation and in non-equity asset classes.

Market manipulation behaviours – narrowing the spread

In order to detect and prevent market abuse, firms need to be aware of – and get up to speed with – emerging behaviours of market manipulation. One such behaviour in the CFD space is that of ‘narrowing the spread’.

This behaviour is defined as aiming to influence the prices of spread bets or CFDs by narrowing the spread in the underlying market, typically in illiquid stocks. Orders are placed on the order book via a direct market access (DMA) broker (using either CFDs or cash equities) to buy or sell a security at prices higher or lower than the current best bid or offer. This narrows the spread of the security and leads to a change in the execution price of the CFD or spread bet, which is based on the underlying instrument. The same, or connected, participant then trades in the opposite direction, in larger size, in a related derivative such as a CFD, often at another broker, benefiting from the improved price. The DMA order is typically cancelled before it trades.

If you have not included this behaviour in your market abuse risk assessment, now is the time to do so. And where such activities have become suspicious, a STORs submission would be expected. Moreover, it is not effective enough to solely rely on trading desk to detect this behaviour, developing compliance-based surveillance would be a recommended best practice.

Surveillance alert investigations

Surveillance can only be as effective as the way alerts are reviewed and investigated.

When reviewing alerts for insider dealing, you should consider the client’s full trading history and not place significant weight on factors such as increased option volumes, financial blog articles and bulletin boards, analyst recommendations and stock sentiment.

Capturing data on clients’ IP addresses and advertising IDs (unique user ID assigned to a device) and using this data to identify potential collusion or links is also considered best practice.

As always, make sure to record your rationale for closing alerts, and put formalised procedures in place for alert investigation to ensure consistency.

Understanding the tipping off risk

It is important to strike the right balance when engaging with front office on surveillance matters. Front office should be trained to recognise and escalate suspicious activities while being challenged by compliance when they haven’t identified or escalated a suspicious client activity.

A clear understanding of what tipping off risk means would also be beneficial to both your compliance team and the front office. This will enable them to provide feedback and further educate the front office on identifying and reporting suspicious activities. It will also empower the front office to do the right thing and, where possible, refuse to accept a client order if information held leads them to conclude that a client is seeking to trade manipulatively or based on inside information.

One thing worth emphasising: STORs should only be shared on a need-to-know basis.

Countering the risk of market abuse-related Financial Crime (SYSC 6.1.1R)

The FCA was encouraged by the fact that all the firms they visited demonstrated they were acting in accordance with their SYSC 6.1.1R obligations as they apply to market abuse. However, it also notes there is still room for improvement in the formalisation and documentation of the risk appetite framework.

And within the firms the visited, the FCA observed varied approaches while acknowledging that there is no one-size-fits-all solution. The key message here, which is not new, is that SYSC framework should be proportionate to the nature and scale of the firm’s business. Firms are advised to regularly review their SYSC arrangements to ensure they remain effective and fit for purpose as their businesses and client bases develop.

How we can help

We regularly help clients assess the market abuse risks they face, designing effective policies, procedures and controls on the back of these assessments. We can test the robustness of your surveillance systems and provide training on the key market abuse risks and obligations.

We partner with KRM22 to provide support to firms on matters concerning market abuse surveillance.

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