Part 1: Definition of market abuse and the techniques used for gaining market information 

A solid reputation for market surveillance may not be the most compelling argument for winning over customers, but it is fundamental in building credibility and client retention.

In this three-part blog series, Capco’s Jeroen Aumand looks at how market abuse is being perpetrated and the challenges for new market surveillance controls/ solutions. In Part 1 we provide a definition of market abuse and the techniques used for gaining market information. Part 2 reviews how offenders try to influence the market, while Part 3 talks about how offenders hide information and other noteworthy behaviours.

In recent years, market abuse scandals have resulted in heavy fines for banks. These losses and new regulations, including MAR, mean that market surveillance is making inroads into big data to support mandatory reporting of suspicious transactions or orders.

But before banks can implement new controls using technologies such as big data, a good understanding of market abuse is key.

We define market abuse as:

1. The (in)direct manipulation of market information to profit from a position
2. Professional misconduct to gain unfair advantage over clients and competitors  

Indirect manipulation refers to the use of facilitators or market mechanisms. This could be, for example, someone who trades on behalf of a “friend”. Or it could involve using orders to mislead the market. Manipulation of information is about gaining, influencing or hiding information.

The applied methods for market abuse depend on an offender’s role and level of sophistication. For example, a professional investor has more tools and capital available for distorting the market than a retail investor. Also, motivations differ. Professional investors may be looking beyond immediate profit, focusing instead on increasing market share or harming a competitor.

Let’s look now at (in)direct manipulation of market information to profit from a position.

Gaining information

“It’s all about who you know”. Insider information

Insider information is non-publicly available information that would create a market movement. How to spot “insiders”? Typically, they will be close to a company’s strategic decision makers, and its sales and accounting information. In the financial industry, even if you are not part of the M&A department, professionals can still use insider techniques by leveraging client information. Examples that can be exploited include client market positions or incoming large orders (e.g. from a portfolio rebalancing). Traders can use non-automated “last look” (a trader’s right to change price prior to providing a binding quote on OTC) to act swiftly on the order information received. Recently a member of a market surveillance team used his access to spy on his trading colleagues to make profitable trades. 

“Make friends in the right places”. The cartel

A cartel is a (typically hidden) association of market forces coming together to agree market prices. The association aims to profit at the expense of other participants in the free market. The cartel gathers information by consulting other members. By allying forces, they can push market prices up and down. They may also use a “lose to win” strategy, whereby a member offers a deal at their expense while expecting a favour in return. Recent scandals highlight poor monitoring of communication channels like chat rooms and phone conversations.

“The truth is out there”. Finding hidden orders

Even when offenders aren’t dealing with insider information, they can search the market for hidden orders and leverage that knowledge by sending a large - fake - order during auctions, for example. Large orders enable the sender to pinpoint iceberg and stop loss orders in the book. Although this is a far from reliable method for finding large professional orders, it is useful for day traders looking for “smaller” orders.

More sophisticated setups allow the use of “layering” during the day: A strategy that involves sending multiple orders in a single direction to the market. At the first order execution, the “layered” orders are pulled out of the market. These orders are not intended for execution but are used to lure orders to the market. Layering has been blamed, among others, for causing the flash crash.