Analysis is becoming surveillance in monitoring of trades

Trading analysis for money managers is moving beyond traditional transaction cost analysis — ensuring best execution and cost control — to watching over the entire lifecycle of every trade.

Regulations such as the Dodd-Frank Wall Street Reform and Consumer Protection Act and the European Union's Markets in Financial Instruments Directive, which require an audit trail for trades, have meant that verification and compliance issues once the responsibility of investment banks and brokers on the sell side have become a duty of buy-side money managers as well.

Those regulations “were a shot across the bow” for the buy side, said Michael O'Brien, head of product development, Nasdaq SMARTS Trade Surveillance, London.

“Regulators are pushing responsibility (for trading) further and further,” Mr. O'Brien said. “Ten to 15 years ago, we would not have seen the push for sell-side trade control. ... And even just five years ago, manager responsibility for trade control would have been unlikely. At each step, regulators have stepped up their trade-control mandate.”

Ted Morgan, CEO of Abel/Noser Corp., New York, said that along with Dodd-Frank and MiFID, programs and guidance from the Securities and Exchange Commission and the Financial Industry Regulatory Authority also have heightened the need for trade surveillance. “There's guidance from FINRA, pilot SEC programs, a lot of regulations related to trading,” Mr. Morgan said. “There's 605 reports (the SEC rule requiring disclosure of trade execution practices), 606 reports (SEC-required quarterly reports on trade routing), the SEC's tick-size pilot, scans to find layering and spoofing.”

That has meant that money managers have had to increase their monitoring of trades from inception to reconciliation, and it's also meant that firms focusing on transaction cost analysis have had to add more capabilities in what sources called trade surveillance — “the repository of all trading activity along with monitoring any potential regulatory or governance violations,” Mr. Morgan said.

“Trade surveillance tools are pretty new to us,” said Peter Weiler, New York-based president of Abel Noser Solutions, the financial technology unit of Abel/Noser Corp. “Primarily, they were used by the sell side, but now we're seeing interest from the buy side, particularly large institutional managers.”

Trade surveillance monitors such actions as marking the close, or valuing stocks higher at the end of each quarter to inflate the overall return; cross-trading in the same security in the same account to get additional trading costs; and spoofing, or seeking a high number of quotes from brokers and then pulling out of the trade at the last minute to influence the price of a stock without executing a trade.

“Monitoring the lifecycle of a trade from creation through settlement is paramount to understanding its risk and impact” on the funds that hold the stocks being traded, said Drew Miyawaki, head of global equity trading at Legal & General Investment Management America, Chicago. He added that LGIMA “views this surveillance as an integral part of fulfilling our best-execution responsibility.”

Using MiFID requirements as an example, Steven Glass, president and CEO at Zeno Consulting Group, Bethesda, Md., said the need to have trade information readily available for regulators is what is driving managers to move into trade surveillance. Zeno is a consultant to money managers and pension funds on trading issues.

“MiFID II requires all money managers that have operations, strategies or clients in the U.K. and Europe to maintain a process to provide a clear audit trail, and that will apply to their trades,” Mr. Glass said. “It might also apply to trade surveillance. Most managers don't have the platform to do this.”

About 30% of Zeno's clients are mutual fund managers that use subadvisers, which means they have oversight needs that could be met by trade surveillance, Mr. Glass said. While asset owners look at trade costs based on their effects on investment performance, he said, compliance officers are pushing mutual fund managers for trading analytics.

“With trade surveillance, what I think of are tools for brokers and exchanges,” Mr. Glass said. “But there are so many requirements these days. ... Yes, best execution is a requirement, but there are a ton of other requirements.”

At LGIMA, Mr. Miyawaki said the firm uses “a collective effort between teams in compliance, risk oversight, trade operations, fund management and trading” to conduct trade surveillance, using a variety of both internally operated and vendor-based systems. Those include a pre-trade compliance system, an order management system and a post-trade transaction cost analysis provider.

Mr. Miyawaki expects trade surveillance use to ride the coattails of transaction cost analysis' progress among managers. Also, he added, “Trade surveillance is an asset class-agnostic exercise. Traditional TCA is widespread in equities, yet is more challenged in other asset classes due to different market structures and availability of market data.”

Abel/Noser's Mr. Weiler added that trade surveillance could become as important as transaction cost analysis to pension funds as well.

“We're starting to make asset owners with internal management aware of this gap in compliance,” Mr. Weiler said. “While right now it's early days for buy-side clients, asset owners haven't been thinking about it, that there is risk here. Egregious errors could affect the managers,” through fines and reputational risk, “and that could lead asset owners to flee those firms. You could see asset owners include (trade surveillance) in RFPs in the future. That seems to be the next step.”

As for pension funds that manage assets internally and have their own trading desks, Nasdaq's Mr. O'Brien said he had no anecdotal evidence of asset owner interest to conduct trade surveillance directly. “But I have spoken to a head of compliance at a pension fund who said (trade surveillance) is where they're going,” Mr. O'Brien said.

“He was shocked at the low quality of data (on trading) within the fund. He had a real sense that they were flying blind, which therefore put the pension fund at risk.” Mr. O'Brien would not identify the pension fund or the compliance chief.

At the $193.4 billion California State Teachers' Retirement System, West Sacramento, spokeswoman Michelle Mussuto said the pension fund has “robust internal controls to prevent rogue and/or improper trading.” Ms. Mussuto also said officials “are not aware of or familiar with other pension (funds) that use these trade surveillance services.”

Mr. O'Brien said asset owners that internally manage assets “are a potential market” for trade surveillance providers like Nasdaq SMARTS. “Pension funds don't have an absolute mandate right now, but I think they're reading the tea leaves.”