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Q&A: Market Surveillance Demands 20-20 Vision

Just because regulators are gaining an IT advantage in market surveillance it doesn't mean that broker-dealers can relax. If they want to avoid fines and keep their trading license, remaining vigilant against suspicious trades and compliance infractions is still Job One.

Two weeks ago, Direct Edge chose the Financial Industry Regulatory Authority (FINRA) to provide market surveillance for its two exchanges, a move that makes FINRA the official overseer of more than 90 percent of U.S. equities trading. But despite FINRA's near complete monitoring vantage point, broker-dealers must remain vigilant against manipulative trading.

Broker-dealers are compelled to monitor all trading activity and report red flags, and even with FINRA's eyes on the markets, broker-dealers must comply with new regulations if they want to avoid large fines or lose their trading licenses. With this in mind, Advanced Trading chatted with Sam Mele, co-founder and managing director of Firm58. His company provides Web-based software to help capital market firms automate their front, middle and back-end processes.

[The Dark Pools have a choice: Into the light or down the drain.]

Advanced Trading: Market regulators seem to be getting their act together when it comes to real market surveillance. Are the days of benign neglect or uninformed monitoring over?

Sam Mele, Firm58: Regulators have always done a good job of overseeing market activity, however, it appears that things have just become more complex and visible, which has led to new laws like Dodd-Frank and resulted in unfortunate events like the Flash Crash in May 2010. Investor confidence in the market and its participants has suffered which has lead to the surge in activity around compliance and surveillance. Adequate self-surveillance can catch market-price manipulative activities. That’s a minimum prerequisite to be a participant in this market today, and with the technology that is available, there are no excuses for lacking these surveillance tools.

Advanced Trading: What do trading firms or broker-dealers need to do to make sure that they can spot suspicious trading activity in time? How are their current systems doing in this regard?

Mele: Not only do they need to review daily trade activity, but they need to look at trends over time to spot suspicious trade patterns that are not apparent when you only slice up a single day. In addition, they need to review several dimensions of trade activities, by trader, client, and asset class. Only when you expand the scope of your surveillance can you truly claim you’re meeting your own compliance requirements. Current systems are much too focused on a single day’s trading activity and generally ignore the other trade dimensions.

Advanced Trading: What are clients telling you in terms of these new challenges? Are they overwhelmed, awaiting more detail or working on the problem?

Mele: Clients are frustrated by these challenges because the rules are vague and the solutions are expensive. The largest organizations are investing in multi-million dollar bespoke solutions, while the small to medium sized BD's struggle with spreadsheets and people to do the best they can. They desire solutions that don’t price them out of the market, where the cost of surveillance marginalizes their profits.

Advanced Trading: Are the solutions to these problems all automated? Do human beings play a role in spotting bad activity?

Mele: Both play a role. Certainly the volume of trading activity creates a big data problem that only technology can parse through to identify the potential violations. But people are also key in terms of hiring, enforcing policies and maintaining relationships to avoid non-trading fraudulent activity that is just as threatening and damaging to the market.

[Have we hit peak HFT? Check out what the numbers say.]

Advanced Trading: Trading firms all claim that their back and middle offices are up to date but are they telling the truth? Where do they need to shore up their systems to make sure they aren't fined by the SEC and other regulators?

Mele: Most organizations spend a preponderance of their budgets on front end solutions (order management, algorithms, data, connectivity to exchanges, etc.) and relegate only a fraction of their investment dollars to the back and middle office. Frankly, the back and middle office is grossly under-invested and severely under-manned, yet ultimately responsible for these surveillance requirements. Eventually the tide of investment will begin to shift to the back office when enough organizations suffer massive fines or go out of business for lack of compliance monitoring.

Advanced Trading: Are firms willing to trust third-party IT vendors for their risk mitigation? Shouldn't they do this themselves in an ideal world?

Mele: Only the largest firms on the street are in a position to avoid third party solutions. The majority of firms must trust third party solutions or they risk failure to meet their compliance and surveillance requirements. If these small and medium sized firms are going to survive and grow they need to focus their internal resources on what they know best … trading. Any investment in in-house, non-core technologies will eat away at margins and defocus firms' efforts away from what they are strategically invested to begin with.

Phil Albinus is the former editor-in-chief of Advanced Trading. He has nearly two decades of journalism experience and has been covering financial technology and regulation for nine years. Before joining Advanced Trading, he served as editor of Waters, a monthly trade journal ... View Full Bio

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