Misconduct Continues…But it is Shifting to New Markets: FMSB
Posted by Colin Lambert. Last updated: May 31, 2022
The Financial Markets Standards Board (FMSB) has published an updated Behaviour-pattern Conduct Analysis (BCA) report, which suggests that shows historical forms of misconduct, which have been present in the financial markets for hundreds of years, are playing out in new digital asset classes, including crypto assets and nonfungible tokens.
The paper also finds that misconduct may also be found in new contexts, such as the sustainable finance market and the post-pandemic hybrid working environment. It reaffirms six core misconduct areas – price manipulation; circular trading, misuse of inside information, reference price manipulation, improper order handling and misleading customers or markets through false information.
The updated report refreshes the original published in 2018, which looked at patterns of misconduct over the previous 200 years, and includes cases that have occurred between 2017 and 2021. It is here that FMSB finds that patterns are repeating themselves in digital asset markets, including NFTs, although it does also point out that other breaches have taken place in traditional markets – most notably a conflict of interest case in Ireland.
In digital assets, FMSB says the risk of market manipulation increases when there is rapid growth in new financial products in evolving markets, particularly when this is coupled with advances in technology and an ever-growing number of new market players. For example, it cites a 2021 Deloitte report that estimates that “as much as 90% of cryptocurrency’s trading volume could be the target of manipulation”.
FMSB points out this may be driven by the novel characteristics of digital assets (which can increase the difficulty of surveillance), the decentralised market structure and limitations on the applicable regulatory perimeter and says this has already been borne out. In August 2020, it was alleged that, between August 2019 and May 2020, the vast majority of the transaction volume on Coinbit, one of South Korea’s largest cryptoasset exchanges, had been subject to wash trading through the use of ghost accounts, the paper says. Concerns about market manipulation and wash trading are also being raised in relation to the rapid increase in prices of NFTs, a form of digital asset that uses blockchain technology.
The Full FX View
It would be easy to look at the FMSB paper and see it as a call for increased regulation in FICC markets, but not only do I believe this is not its intent, it would be the wrong conclusion at which to arrive.
There is a sense in markets that they are no governed by the “consenting adults” concept, but this remains an important part of OTC markets especially. Fears of a dilution of this ethos are largely the result of the blurring the lines between retail and institutional, such as we have seen in FX and are very much seeing in crypto.
Markets operate better with less regulation, but less informed traders need to be protected – that is why there should be firm boundaries between retail and wholesale. If those are in place the latter can get on and do what it does best, innovate and operate as efficiently as possible within guidelines established by the industry that everyone is aware of. This is how “consenting adults” model works best, when everyone understands the boundaries and are able to identify when they are crossed.
Crypto markets have inevitably seen bad behaviour, it is hard to avoid when the markets are born out of retail investors’ appetite for quick and hefty returns, but this is also the result of a time-old characteristic highlighted by FMSB – regulation’s inability to keep up with technology.
There is little doubt that if digital assets are to attract institutions on a serious scale they need a regulatory framework so that we can avoid ridiculous circumstances wherein a creator of an NFT establishes a “value” for their NFT by selling it to themselves. Crypto assets, however, as “trustless” markets, do not lend themselves to “consenting adults” models, thus it will be a tricky balance for the industry to develop with adequate regulation while at the same time being able to fund the associated requirements through revenues. What would help crypto markets is the establishment of a firm boundary between retail and wholesale – probably, though, that train has already left the station.
Interestingly, the updated paper also steps into the AI world, observing that regulators have been aware of the conduct risks posed by AI and machine learning for several years, in particular, the lack of explanation of results and ‘breadcrumb trail’ that manual traders often leave can make it difficult to find evidence of intent, as well as algorithms that may have the ability to ‘game the system’, without understanding the limits of permissibility or having a sense of conscience. “Some machine learning algorithms may systematically work out parameters that Compliance would see as high conduct risk and look for gaps they could exploit,” the paper states. “There are also continuing concerns regarding novel scenarios in which, through self-learning, ‘autonomous AI trading agents… discover both old and new forms of market abuse’, including forms of collusion.
The paper does also point out, however, that such advances in technology, whilst facilitating certain forms of misconduct, are also increasing the world’s ability to detect manipulation. AI is increasingly being used as a communications surveillance tool to interpret the context of human language and detect human intention, it says, using as an example the way the software can identify and alert supervisors where it detects misconduct (such as traders making a plan to manipulate a market).
Regulators have also emphasised the role that AI and machine learning will play in simplifying and speeding up detection of misconduct, it continues, such as through the design and implementation of ‘screening algorithms’ to monitor and identify risks and manipulations. It adds that both the FCA and SEC have invested in supervisory technology that identifies potentially abusive behaviour by running surveillance algorithms over trade data gathered from trading venues.
Enduring patterns of history can therefore be broken as firms better anticipate and design out patterns of misconduct
The paper also chimes in on “greenwashing” in ESG, “meme stocks” and hybrid working, on the latter observing that traditionally compliance has relied upon co-location and “line of sight” for surveillance – it also notes the increased use of un-monitored or encrypted social media channels such as WhatsApp.
“It is often colloquially observed that major financial crises occur once every generation because the next generation forgets the lessons learned by the previous one,” FMSB says in the paper. “This volume has its origin in a simple question: ‘what can we learn from past episodes of market misconduct in order to pre-empt conduct problems that may arise today?’.
“This question remains as relevant as ever in today’s rapidly evolving environment in which market participants are grappling with a raft of the same conduct challenges in new settings,” it continues. “However, the wholesale financial services industry is arguably better equipped than ever to reduce future misconduct through the development of more effective controls, assisted by advances in behavioural science and a broader mindset shift. Enduring patterns of history can therefore be broken as firms better anticipate and design out patterns of misconduct.”
On a less optimistic note, FMSB also observes that the nature of regulation tends to be “reactive”, which may be why, despite the introduction of new laws and regulations, patterns of behaviour that drive misconduct still recur.
“Government indebtedness and reliance on wholesale markets have never been greater post-pandemic,” says Myles McGuinness, CEO of FMSB. “Our members know that integrity matters now more than ever, no matter how adept artificial intelligence is at spotting misconduct, it can also be a tool for creating it.
“This work remains as relevant as ever in today’s rapidly evolving environment in which market participants are grappling with a raft of the same conduct challenges in new settings,” he continues. “The wholesale financial services industry is arguably better equipped than ever to reduce future misconduct through the development of more effective controls, assisted by advances in behavioural science and a broader mindset shift.
“This research is also an exercise in the collation and analysis of market misconduct for the purposes of recognition, and to support, among other things, management oversight, training and control function oversight,” he adds. “We simply wanted to find out what can be learned from past episodes of market misconduct to pre-empt conduct problems that may arise in the future.”
David Flowerday, chair of the FMSB BCA Committee and head of EMEA markets and securities services compliance at Citi, adds, “We hope this piece of research will be a valuable reference point for wholesale financial market participants. This analysis highlights the repetitive nature of financial market misconduct over an extended time period. Given the pace of innovation and change, the intention is that market practitioners can use the BCA framework, supported with illustrative case studies, to inform their business practices, help eradicate poor behaviours, and continue to build trust in financial markets.”