Regulators to take steps on trade surveillance

Regulators are set to require FX market participants to add sophisticated surveillance technology to their electronic trading infrastructure as the next step of measures in the wake of the global regulatory investigations.

Since the launch of the probe into allegations that some traders sought to manipulate the WM/Reuters currency benchmark, the lack of visibility in trading patterns and electronic orders has triggered an intense focus on surveillance technology among both dealers and regulators.

One authority has already recommended its regulated firms use this type of data analysis system to root out misbehaving traders, says David Hesketh, chief operating officer of the Financial Skills division of Markit.

"My belief is that regulation will require a specific legal obligation for surveillance software, alongside alterations to benchmarking procedures," he says.

Hesketh has worked with a number of major regulators during the now year-long global probe into currency markets, using surveillance software able to detect unusual and suspicious patterns of trading behaviour.

"We were able to identify 1,000 cases for a particular regulator involving suspicious trading activity," says Hesketh. "We have performed analysis on over a billion trades, covering five million traders, for regulators all over the world. We can gauge the mean skill rating in different asset classes and how many standard deviations away from the norm a significant event represents."

Users of surveillance software, be they regulators or financial firms, can hone in on traders who display a skill level of three to four standard deviations above the norm and, from that point, prioritise their investigation.

Despite more than 60% of currency trading being routed through electronic channels, trade surveillance has failed to keep pace with the electronification of the market, partly due to the high costs associated with such systems.

Experts have warned that investigations could take much longer than expected due to the lack of real-time monitoring systems and the sheer volume of trade data that regulators will have to wade through to find the right behavioural patterns.

As part of the efforts to 'clean up' currency trading, the UK's chancellor of the exchequer, George Osborne, announced last week that FX, fixed-income and commodity benchmarks will soon fall under the same trading behaviour legislation that now covers the much-discredited Libor process.

However, market participants were underwhelmed by this announcement, claiming an automated, sophisticated monitoring system for the FX market is required to make criminalisation of benchmark manipulation effective.

"The former can bolster the latter, as new regulation can create pockets of abuse that didn't exist before," says Hesketh. "Performance metrics are a very good lens through which to examine possible manipulation. The driving force behind any abusive or manipulative behaviour is the desire to make money, so you can reduce the number of false positives by excluding people who are not making money. We offer a way of finding people who make profits in a way that is too uniform and predictable."