Expanding Your Compliance Program – Trade Surveillance

Expanding Your Compliance Program – Trade Surveillance

Why should trade surveillance be a critical component of your compliance program? The short answer is that the devil is in the details of a firm’s trading. Reviewing trading can be a window into identifying conflicts of interest and a means of assessing the efficacy of a firm’s trading policies and procedures. It can also demonstrate your firm’s commitment to fulfilling its fiduciary duty in terms of both the duty of care and duty of loyalty. For example, trade analytics, or slicing and dicing trading data, can assist with identifying whether one client account is being favored over another. It can also be used to determine the quality of trade execution and transaction costs. Additionally, trade blotter data is a key element to identifying personal trading violations, such as front running.

Understanding the lifecycle of a trade serves as a foundation for appreciating how data analysis can be used to assess the effectiveness of a control and identify breaches of policies and procedures. The trading lifecycle is comprised of three (3) stages: pre-trade, trading and post-trade.

  • Pre-trade Stage: This is the stage where research is conducted, ideas are generated, investment guidelines and restrictions are reviewed and order entry takes place. The risks associated with this stage include, but are not limited to, market abuse, insider trading, and prohibited or restricted transactions.
  • Trading: At this stage of the process, order aggregation, trade sequencing, broker selection and trade execution take place. Account favoritism, side-by-side trading, the quality of broker execution can be evaluated through trading.
  • Post-Trade: After a trade is executed, the post-trade activities include trade settlement, reconciliation, and final trade allocations. Risks present in these activities include fairness of allocations, account favoritism and prohibited transactions. The last stage of trading also provides an opportunity to review position levels and investment guideline compliance to determine guideline breaches, restricted transactions and if regulatory filings are required.

It is equally as important to understand the risk factors associated with trading. The chart below provides a summary of risks associated with certain trading activities and at what point in the trade cycle they are relevant. (It is by no means a comprehensive list as risks will vary depending on the instruments that your firm trades.)

Best Execution-Broker Conflicts
-Poor Execution
-Transaction Cost Analysis (Equity, Fixed Income, FX)
-Soft Dollars/Client Referrals
Side by Side Management-Unfair Trade Sequencing
-Order Aggregation
-Trade Allocation
-Cherry Picking
Market Abuse-Wash Trading
-Aggressive Short-Selling
-Contract Based Market Manipulation
Délit d'initié-Aberrational Performance (Realized, Unrealized, Loss Avoidance)X  
Prohibited Transactions-Window Dressing and Portfolio Pumping
-Cross Trades
-Rule 105 of Reg M
-Style Drift
-Guideline or Limit Breaches
-Unreported Trade Errors

Once the risks are identified, the next step is to develop a testing program. Post-trade testing enables you to identify individual trades that may violate a policy as well as identify trends, which over time may be problematic. The steps in developing an effective post-trade testing program are:

  • Define the Data. A daily consolidated trade blotter is a starting point, as it shows all trades executed in client accounts. In addition, account positions, relevant benchmarks and historical price and volume data enable a more fulsome analysis. Position data provides cumulative information about holdings and can be used to calculate ownership percentages needed for regulatory filings. Benchmarks allow your firm to assess the quality of trade execution as does pricing.
  • Define Target Activities. In other words, decide what you’re testing for. Define trading patterns and how to detect them. It is helpful to frame your tests in the form of simple questions, such as:
    • “Show me instances in which trades in the same security were executed at different prices across different accounts.”
    • “Show me all trades where there is a buy and sell transaction in the same account on the same day.”
    • “Show me all cross trades.”
  • Identify Thresholds for Testing. Think about what levels of activity are important for analysis or give rise to a potential conflict. For example, if you’re testing for short-term gains, consider instances in which a security was bought and sold for more than a 15% gain within 10 days.
  • Develop the Data Model. Define the test criteria within your analysis tool to and load data to produce some sample output.
  • Tune the Model. Initial expectations about data models often provide a significant number of false positives. Continue to refine the threshold criteria, account and trade populations, etc. to filter out the noise. One example may be to distinguish between trades based on model portfolio changes vs. trades related to individual account cash flows.
  • Build Reports. Effective reports should convey the results of the analysis and evidence compliance with policies and procedures. Reports should reflect both individual trading activity and trends over time. Reports should be clear and understandable for the intended audience.

The ability to conduct such detailed reviews often is a question of resources. But it is also a question of expertise and independent oversight. Firms can accomplish conducting trade analytics in a number of ways. They can devote in-house resources to develop the skill set needed to evaluate trading data. In-house resources need to include systems or technology solutions in addition to qualified personnel. Ideally, in-house responsibility for trading analytics is vested with a person or team that is not associated with the trading function. This separation of duties provides for independent oversight.

Another option for firms is to engage an independent third-party, such as a compliance consulting firm, to conduct trade analytic reviews. The key to a successful engagement is to conduct due diligence of whoever you wish to engage. In particular, verify that they have a robust system for analyzing trading data and that the data that they require for a review is safeguarded. Also inquire as to the experience and skill set of the person or persons who will be analyzing the data. And lastly, clearly define the deliverables that your firm requires, such as the form and frequency of reports.

Trade analytics is an essential element of your firm’s compliance program. The testing and reviews that are conducted throughout a year can be used in your Rule 206(4)-7 annual review. And whether you conduct the reviews internally or utilize a third-party to expand your compliance resources, trade analytics is an important tool to evaluate the effectiveness of your policies and procedures and identify conflicts of interests.