Market Abuse Regulation expands the original Market Abuse Directive (MAD) to require FIs to monitor abusive trading behaviour not just on the single product level, but also across all related products: ‘cross-product manipulation’. MAR states that
“Financial instruments, irrespective of whether or not they are traded on the same trading venue, may be targets for cross-product market manipulation, notably where the price or value of a financial instrument depends on or has an effect on the price or value of another financial instrument”.
‘Cross-product manipulation’ could be simply described as placing orders or executing trades in one financial instrument in order to affect the price of a related financial instrument. MAR defines it as:
“trading on a financial instrument to improperly position the price of a related financial instrument in another or in the same trading venue or outside a trading venue as undertaking trading or entering orders to trade in one trading venue with a view to improperly influencing the price of a related financial instrument in another or in the same trading venue or outside a trading venue, related spot commodity contract.”
Despite claiming to meet MAR requirements for cross-product manipulation however, certain established vendor out of the box models are missing this important coverage. These vendors didn’t change their existing single product manipulation models to look for cross product manipulation. Instead,they began feeding alerts produced by existing single product manipulation models as an input into new ancillary cross-product manipulation models. The approach of looking for cross-product manipulation using alerts produced by single product manipulation models is flawed, as it assumes that cross product manipulation always accompanies single product manipulation. This assumption is not grounded in reality, or regulation, and clearly misses all “pure” cross product manipulation without accompanied single product manipulation.
Examples of cross product manipulation and regulatory actions support the fact that, in most cases, violators are sophisticated and are trying to manipulate across products without engaging in single product manipulation. The well-known ISDAFIX scandal for which global regulators CFTC in US and FCA in UK levied billions of dollars in fines on major FIs involved in the manipulation of ISDAFIX rates is a prime example of pure cross product manipulation.
- ISDAFIX (currently ICE Swap Rate) is recognized as the principal global benchmark rate paid on the fixed leg of the interest rate swaps (IRS) of varying maturities.
- USD ISDAFIX IRS swap rate is the sum of the rate of the on-the-run U.S. treasury of the same tenor and corresponding swap spread.
According to the regulators, traders at multiple FIs were bidding, offering, and executing transactions in US treasuries and swap spreads at or near the critical 11:00 a.m. fixing time of ISDAFIX rate. In other words, traders were marking the close of ISDAFIX by trading related financial instruments: treasuries and swap spreads. The CFTC complaint states that traders
“attempted to manipulate USD ISDAFIX by bidding, offering, and executing transactions in targeted interest rate products, including swap spreads and U.S. Treasuries at or near the critical 11:00 a.m. fixing with the intent to affect the reference [treasury] rates and [swap] spreads captured in the snapshot sent to submitting banks, and thereby to affect the published USD ISDAFIX.”
The approach, used by some vendors, of looking for cross product manipulation using alerts produced by single product manipulation models would fail in this case. There wouldn’t be any Marking the Close alert(s) produced for orders and/or trades in US Treasuries or swap spreads at 11am to be fed into ancillary cross product model.
Another example of “pure” cross market manipulation is CBOE and NASDAQ disciplinary actions against Lime Brokerage LLC:
“customer of the Firm [Lime] engaged in trading of equity securities to create a false, misleading or artificial appearance in the price of those securities and options overlying those securities. Those transactions triggered activity and price movement in the equity securities, which in turn impacted the price of the overlying equity options and enabled the Firm’s customer to purchase or sell the overlying equity options at more favorable prices. Depending on the economic rationale for effecting these transactions, they could have constituted a cross-product or mini-manipulation. Additionally, the firm did not have adequate electronic surveillance to detect such cross-product trading or options spoofing activity.”
In other words, Lime customers were placing market-moving equity orders (which moved related equity options prices), executing trades in those related options on the other side of the original equity orders, and canceling original equity orders.
Again, some of the vendors’ approach of looking for cross product manipulation using alerts produced by single product manipulation models would fail in this case. There wouldn’t be any single product spoofing alerts produced in this case because single product spoofing alerts require both orders and opposite side executions in the same equity product. In the case above, only entered and cancelled equity orders would exist; there wouldn’t be any opposite side equity executions.
The approach of using ancillary cross product manipulation model leaves FIs at risk that manipulation similar to the type used in the ISDAFIX scandal, mini manipulations involving equity and related equity options, and many others would go undetected.
What action can you take?
- Consider asking your compliance vendor if they can perform cross-product market surveillance and, more importantly, how they do it.
- We can inspect your company’s installed trade surveillance models to verify their ability to address MAR’s cross product manipulation risk behavior by putting those models through test cases developed by our experienced compliance professionals.
- If existing model gaps are found, we would document those gaps with use cases, identify reasons for use case failures, and propose fixes or alternate models to rectify the situation.
- We can also examine your firm’s trading businesses and identify risks (missing models from inventory) in order to bring your firm into full compliance with MAR. We will tune all existing and new models for best performance to minimize false positives and missing alerts.
It is paramount that your institution does not blindly rely on your vendor’s claim that their models are MAR compliant, but rather has independent and experienced advisors verify those statements. The price of reputational damage and regulatory fines far exceeds the small and imperative investment needed for this independent, professional review.
This article is written by Senior Business Analyst Boris Sherman. Read more from the same author:
