Detectives race to get inside line on fraud

When the bell rings at the New York Stock Exchange every morning, traders get to work. So do investigators charged with detecting market abuse.

But in recent years, a confluence of factors has made the monitoring of insider trading and market manipulation more challenging. The growing sophistication of investors, the surge in electronic trading and the use of overseas accounts to trade US stocks means authorities have to constantly adapt their strategies.

“The classic 1980s type of insider trading did not involve hedge funds, which have an important presence in markets now,” says John Malitzis, executive vice-president of NYSE Regulation’s market surveillance.

“A lot of players are using cross-product strategies, people are not just trading listed stocks, but related options and exotic derivatives, making spread bets . . . things they didn’t do 10 years ago.

“So we are making efforts to stay out in front of trading as trading changes.”

Indeed, investigators who once depended on spreadsheets and other basic tools now increasingly employ complex computer algorithms and automated databases to do their detective work.

While a small group of investigators are the “eyes and ears” on the NYSE trading floor, where some activity is taped, the bulk of work is done by analysts off the floor using existing sophisticated surveillance tools. Another group looks for other surveillance methods to detect new kinds of illegal behaviour.

At the same time, more than 230 miles away in Rockville, Maryland, investigators at the Financial Industry Regulatory Authority, a non-governmental body that oversees broker-dealers, are monitoring other groups of stocks, including those that trade on Nasdaq.

Cameron Funkhouser, senior vice-president of market regulation at Finra, says insider traders “leave footprints” and “they are greedy”. “Insider trading rings start out small and start [to] place bigger and bigger bets. No matter what size the trade is, we can detect it,” he says.

Soon, Finra and NYSE Regulation, which are themselves overseen by the US Securities and Exchange Commission, may soon be responsible for monitoring market abuse across all nine US equity exchanges under a new plan likely to be submitted to the SEC as early as this week.

Until now, each of the nine stock exchanges, incl­uding small regional markets, have maintained their own monitoring programmes but that has led to duplication of efforts in some cases and raised the prospect that potential illegal activity could go undetected.

The exchanges and industry regulatory bodies are required to monitor the activities of their market participants, gather evidence and refer cases to the SEC. Finra has referred 104 cases of insider trading to the SEC so far this year, compared to 118 last year, and NYSE Regulation, as of the end of June, has referred 90 cases, compared to 141 for all of last year.

Some high-profile insider trading cases have emerged from such referrals, including a case last year in which the SEC charged 14 defendants in an insider trading scheme the regulator said involved hedge funds, lawyers and employees at UBS, Bear Stearns and Morgan Stanley.

At Finra, the key computer programme at the centre of the operation – Sonar – was developed on-site and is able to process any unusual stock movements into an algorithmic programme that finds any related news stories or announcements.

It searches anywhere bet­ween 25,000 and 50,000 news stories a day for key words – such as “merger” or “acquisition” – which are constantly adjusted. Trading data on a particular stock can be screened in multiple ways, including trading volume and issuer history.

There may be explanations, such as breaking news affecting a share price. Perhaps the company has put out a statement. But many situations require analysts to obtain “bluesheets” that show all trades that occurred and by whom within a time period.

“For instance, the same investment bank might have been the adviser for all five deals in which we see suspicious trading so that might be where the information leak is,” says David Steiner, vice-president of NYSE Regulation’s market surveillance.

“In the past, it was all manual detective work, but now with databases, we automate a lot of stuff. We also do zipcode and geographical matches.”

In the past two years, investigators have also increasingly focused on “cold case” data. “If we see someone trading in a stock in a suspicious way, we look at cold cases to see if their names appear in those files but were previously undetected,” Mr Funkhouser says.

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