2017Buy Side Trade Surveillance Handbook

Introduction

How to use this guide

Table of Contents

Your 2017 Buy Side Trade Surveillance Handbook is designed to provide a concise overview of the current trade surveillance challenges and actionable advice based on the unique needs of your firm. The handbook includes advice from subject matter experts and industry analysts along with the best practices of your peers.

Review the Challenges ............................................................................... 4

Define Your Compliance Risk Control Requirements ..................................... 5

Understand Your Firm’s Unique Needs ..........................................................6

Hedge Funds ..................................................................................... 6

Traditional Asset Managers ................................................................. 7

Wealth Management Firms ................................................................. 7

Discover Changing Organizational Approaches ............................................. 8

Select the Right Solution ............................................................................. 9

Why Actimize Markets Surveillance ............................................................. 10

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Review the ChallengesEvolving business models and expanding global regulations have increased the regulatory burden on hedge funds, traditional asset managers and wealth management firms. Today, Buy Side firms must comply with many regulations including MAR, MiFID, Dodd-Frank and the Investment Advisors Act. To enforce compliance, regulators have armed themselves with sophisticated technologies to identify insider trading and detect market manipulation. They also created teams dedicated to investigating private funds. Many Buy Side firms have responded by implementing advanced trade surveillance systems enabling them to meet their regulatory obligations, protect their reputation and preserve their business.

During a recent webinar titled Navigating the Seismic Shift in Buy Side Compliance, NICE Actimize along with Aite Group and PwC outlined the following trade surveillance challenges impacting Buy Side firms:

Detecting insider trading and market abuse associated with complex strategiesIdentifying intent and stimulus behind market manipulationMonitoring transactions across multiple markets

Complying with complex and far-reaching regulationsUnderstanding and implementing surveillance solutions in a cost-effective manner

2017 Buy Side Trade Surveillance Handbook

Top Buy Side Trade Surveillance Challenges

“One could easily make the argument that Buy Side firms are subject to a far more encompassing, complicated, and complex regulatory framework than their counterparts on the Sell Side.” - From the article Are Best Practices Being Reinvested in Hedge Fund Risk Compliance? by Stephen Anikewich, NICE Actimize Head of Compliance

“Over the last three years, we have changed the way we do business on the enforcement front by using new data analytics to uncover fraud, enhancing our ability to litigate tough cases, and expanding the playbook bringing novel and significant actions to better protect investors and our markets.” - Mary Jo White, former SEC Chair

Define Your Compliance Risk Control RequirementsEvery firm has a different set of compliance risk control requirements based on a number of key business factors. Review the chart below to better understand the controls you should consider based on your specific trading strategy, trading practices, business strategies and enterprise complexity.

Factor Business Approach Compliance Risk Controls

Trading Strategy

Trading Practice

Business Strategy

Enterprise Complexity

Buy and hold investment strategy with long term horizons

Automated electronic trading systems

Micro business focus, trading across few asset classes

Focus only on one Buy Side audience

Active trading strategy with a high volume of orders, order amends, and trades

High frequency algo trading

Macro business focus, trading across all asset classes at a macro trading strategy level

Multi-faceted and encompasses Buy Side models and Sell Side/investment banking models

Deploy effective controls for key areas including insider trading, conflicts of interest, window dressing, quality of executions, research unbundling, etc.

Address operational risk including “rogue” algo risk.

Connect the dots between any activities flagged by alerts and the trading activities and/or risk positions in all related financial products (including OTC bilaterals). Additionally, implement sophisticated behavioral and pattern-based analysis.

Risk case manager that allows for the delegation and discharge of responsibilities for 1st and 2nd lines of defense, and provides an audit trail.

Go beyond the analysis of executions and ensure you have the ability to identify intent via the analysis of orders, and cancellations/corrections. Additionally, implement the proper controls to detect insider trading.

Implement scalable controls that address high frequency data along with sophisticated algorithms that distinguish between “following/reacting to the crowd” versus manipulating the market.

Same as above, but across all asset classes, particularly for FICC, and their OTC dealings and positions.

Advanced risk case manager that supports a holistic approach at the enterprise level along with a standardized risk management platform, integration of all risk silos, and coordination across the enterprise.

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Understand Your Firm’s Unique Needs Hedge funds, traditional asset managers and wealth management firms have different trading and business strategies requiring different types of risk controls. The following summarizes the key threats and recommendations to protect different types of Buy Side firms.

Hedge Funds

Compliance risk controls for hedge funds should map to their specific business models and strategies. While each strategy has commonalities with respect to compliance risk, the scope of that risk and the analytics and algorithms required to address that risk, vary. Regardless of their individual business factors, hedge funds need to put the proper controls in place to mitigate insider trading. Violations for insider trading can trigger redemptions and even the demise of the firm. To reduce their risk, hedge funds need trade surveillance models that detect insider trading with intent as well as wash trades and price ramping. For hedge funds engaged in high frequency trading (HFT), it’s important to detect layering both preceding and following the opposite side of orders along with quote stuffing by number and volume of quotes and orders. Equally important for such firms is the detection of fictitious orders away from the spread and spoofing within the spread. Ultimately, hedge funds need a surveillance platform that is intelligent enough to connect the dots between trade and communications data. This holistic approach allows firms to tie communications with suspicious trading activities, and both uncover and discover intent. In addition, many firms are now implementing behavioral analytics that can detect anomalies in an individual’s normal behavior, enabling them to detect insider trading and other hidden threats, more efficiently and effectively.

2017 Buy Side Trade Surveillance Handbook

Traditional Asset Managers

Although the compliance risk management needs of traditional asset managers are defined by their investment and trading strategies as well as their enterprise complexity, there are a number of key compliance considerations. First, financial instruments covered by both market manipulation and insider dealing have been broadened to include all dealings in those instruments — regardless of the product, where that instrument is admitted to trade, or where the transaction occurs. Second, the organization’s compliance controls must be able to identify intent, even if no transaction resulted. Thus, orders and quotes must be monitored and analyzed to detect for all instances of nefarious intent. As an example, insider dealing offences in various jurisdictions now include using inside information to cancel or amend a pre-existing order. Finally, transmitting false or misleading information in relation to any benchmark or any other activities that are intended to manipulate the calculation of a benchmark are no longer just a Sell Side issue, asset managers are now equally required to have the controls in place for monitoring the activities of their traders and portfolio managers. That being said, arguably the biggest challenge for this group resides in the large number of global regulations and legal requirements at the advisory and market participant levels. Because of this, it is preferable that traditional asset managers implement compliance controls at the enterprise level — rather than in geographical silos — that support multiple instruments and regulatory jurisdictions. A holistic solution that integrates both trade and communications surveillance at the enterprise level will go a long way in addressing global regulations while enabling the organization to standardize on policies, procedures and risk controls.

Wealth Management Firms

Suitability and best interest are key compliance risk control requirements for wealth management firms. Meeting regulatory standards for suitability and best interest can be challenging as these two areas require separate controls, but often demand integration to fully identify and risk mitigate recommendations and dealings with clients. Additionally, organizations must take into account the potential untoward activities of their clients that relate to market manipulation/abuse, insider trading, and other regulatory and legal requirements. The appropriateness of recommendations and advice to clients in the context of the client’s KYC and risk profile have historically been the key compliance drivers for wealth management organizations. Now, an equal emphasis needs to be placed on any fiduciary responsibilities that may attach, by regulations or contractual obligation, to their client relationships, and firms must take ownership for the self-directed activities of their clients too. Due to the regulatory requirements, proscriptions, and expectations, it’s important to have a solution that covers a broad range of sales practices issues in order to meet regulations and ensure investment recommendations and dealings are in line with each client’s objectives and suitability profile. Additionally, wealth management firms need comprehensive trade surveillance across all asset classes and products in order to detect insider dealing, market abuse, and cross-venue, cross product/market manipulation. In order to truly be proactive, firms should consider an integrated trade and communications solution along with holistic behavioral analytics – in order to uncover both known forms of market abuse as well as hidden behavioral threats.

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Select the Right SolutionWith changing trading strategies and practices, the Buy Side is no longer able to detect the volume and diversity of orders, trades, and conflicts manually. Additionally, regulations now require that you connect the dots to intent behind trades, their market effect, and other related transactions. This requires sophisticated surveillance solutions that can scale to your trading strategies and trading methods. Our experts at NICE Actimize have outlined the following must-haves to look for when selecting a surveillance solution:

Comprehensive surveillance: Your solution should include a diverse range of out-of-the-box detection scenarios that support multiple regulatory jurisdictions and lines of business and cover all of your asset classes. The solution should also be able to analyze data from both a local and global perspective. User-friendly case management: It’s critical that the solution you choose have an easy-to-use case manager that supports efficient alert management, ad hoc investigation, and audit trail functionality. This will improve communication and compliance, while optimizing your limited resources and minimizing redundant efforts. Flexible Deployment Options: You need deployment options to meet your infrastructure and business requirements. On-premise installation is best for firms that prefer to keep their data on-site or want a customized solution, while a Cloud solution is best for firms with limited IT support and/or that need to limit their capital spend on compliance risk management (e.g. budget restraints).Integrated Trade and Communications Surveillance: A holistic approach to compliance that combines trade and communications data is becoming a requirement in today’s regulatory environment. This approach enables firms to proactively analyze all trading interactions, while monitoring the full trade life cycle. Ask your vendor about their ability to integrate both trade and communications surveillance. Holistic Behavioral Analytics: One area that become a focus for regulators over the past few years is conduct risk. This type of threat often remains hidden because human behavior is difficult to model. Ask your vendor if they have holistic behavioral analytics as part of their trade surveillance solution. This will enable your firm to uncover hidden threats, including those related to insider trading, by identifying deviations from normal behavior. By combining holistic behavioral with trade surveillance you’ll be able to analyze traditional alerts alongside the associated behavioral risk factors—improving accuracy and accelerating investigations.

Discover Changing Organizational Approaches The Buy Side is rethinking their approach to compliance risk due to the following business model and regulatory shifts:

Increased regulations: Today, firms must comply with many regulations including MAR, MiFID, Dodd-Frank, the Investment Advisors Act, and the Alternative Investment Fund Managers Directive (AIFMD). For those participating in multiple regulatory jurisdictions, compliance has proven both resource and capital intensive. Trading strategies: Many Buy Side firms have taken on more complex trading strategies, spanning across multiple asset classes. This has made it difficult to develop a comprehensive view of risk within their current compliance programs. Trading practices: Adoption of automated electronic trading has increased the speed and volume of orders, order cancellations and amendments, and trades, increasing exposure to risk. Regulator technologies: To enforce compliance, regulators have armed themselves with sophisticated technologies to identify insider trading, uncover conflicts of interest, detect market manipulation, and monitor automated trading (especially High Frequency Trading).

These shifts have increased regulatory scrutiny, and Buy Side firms are augmenting and adjusting their compliance function accordingly. The following chart shows the changing roles and new approaches for those involved in Buy Side compliance. How does your business compare?

2017 Buy Side Trade Surveillance Handbook

1st Line(Front Line Management and their designees)

Passive involvement in surveillance and monitoring Respond to queriesAssist with root cause analysis

Surveillance and monitoring of compliance riskFocused on post trade surveillance

Conduct internal auditsFocus on adequacy of 1st and 2nd line surveillance policies and proceduresNo active role within surveillanceActively test modelsIdentify compliance risk gaps

Active involvement in risk surveillanceCollaborate with second lineDefine risks that are being monitoredTake more of a real time approach to risk mitigation

Adopt sophisticated surveillance technologies (including holistic) Collaborate across compliance functions including trade, AML, communications, transaction monitoring, fraud, etc.Monitor more on a real-time basis Focused on intent

Adopt data analytics to understand efficacy of modelsEmphasize improving data qualityAudit “who, what, how, and when” through risk case management (audit trail reviews and testing)

What risks should we be monitoring? How can I work more closely with the second line of defense?

How are alerts related across orders, trade, communications, AML, fraud, and transaction monitoring? What new surveillance technologies and techniques should I investigate and invest in?

Are my models working?How can I improve the data sets my models are using?

2nd Line(Compliance Teams)

3rd Line(Internal Auditors)

Line of Defense New Questions Being Considered

New ApproachOld Approach

In a recent study by Infosurv, 41% of respondents plan to implement behavioral analytics into their surveillance program in the next 12 months

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Why Actimize Markets Surveillance

Low Total Cost of Ownership

Award Winning Case Management

Flexible Deployment Options

Proven OTC Models

Cross-Product and Market Surveillance

Market Leading Trade Surveillance

Integrated Trade & Communications Surveillance

Holistic Behavioral Analytics

Sales Practices & Suitability

If you would like help with your compliance efforts please contact info@niceactimize.com.

2017 Buy Side Trade Surveillance Handbook10

2017 Buy Side Trade Surveillance Handbook