Electronic Market Microstructure

The speed in which electronic trading now takes place is forcing market supervision and market surveillance to be become electronic, semi-automated, and real-time. This combined with the adoption of Reg. NMS in the US and MiFID in Europe has created even a greater need for market surveillance to be ultra-fast, predictive and adaptive. No longer will surveillance technology be “labeled” pedestrian or back office slop work. It will be akin to high tech MI5 or CIA overt type capabilities.

The primary objective of a modern surveillance department is to maintain a fair, and the most efficient market, for all participants. A fair market is one where all participants face a transparent set of trading rules which are effectively enforced. An efficient market is one where instantaneous exchange of securities for cash, or cash for securities, takes place at the lowest possible cost quickly. These objectives are sought after by all the different market participants including; broker-dealers, exchanges, ATSs, and clearing & settlement houses. Each participant, acting as layers of surveillance, provides compliance assurance so that the transaction moves to the next party with a high confidence that it complies with all regulations.

Most traditional surveillance systems are tailored for a non-electronic world. They are basically a large database of regulatory definitions that are used to instantiate exceptions when a suspicious trade is identified. This form allows the user to drill down into the data in order to inspect and identify exceptions that actually violate a rule. Starting from a broad view of the exchange, the system would then monitor the trading activity of each firm, individual trader, and the nature of each individual trade. This method forces many exceptions to the surface and requires experienced human intervention to decipher true breaches of the rule or just unusual trading behavior. It is, in other words a sophisticated real-time filter.

The New York Stock Exchange (NYSE) has launched a system called Ask Market Surveillance, a software-based legal research tool for helping floor members and their legal and compliance officers search and answer questions about NYSE trading rules.

“We are putting in one place all of the types of information that are really relevant to [floor members and floor member organizations] who have questions about trading on our floor,”

Nancy Reich, VP market surveillance at NYSE Regulation

The system above looks for exceptions so they can be mitigated creating the fair treatment of customers and the maintenance of orderly markets. This is more than a statutory mandate for an exchange – it’s an essential ingredient for their ultimate success. In our view, the key to an effective trade practice and market surveillance program is to:

• identify the abusive practices which the exchange wishes to deter;
• define the factors which could indicate the presence of the problem;
• design programs to sift through trading data and generate certain core exception reports when the factors are found and which have the flexibility to tailor additional reports to particular circumstances; and
• have experienced and capable staff in place to monitor trading activity, to review data from exception reports, to conduct any necessary inquiries, and to report any findings to the appropriate exchange committee.

Market  Surveillance

Should any security exhibit unusual patterns of trading, it is automatically flagged for further analysis. Computers are also relied on to track securities and individual members’ activities over an extended period of time to detect potential abuses that may not be obvious from a single day’s trading. Notwithstanding the sophisticated hardware, people are at the heart of the detection process. In addition to our surveillance analysts, our listed companies and our floor members are sensitive to unusual trading patterns and they do not hesitate to bring them to the attention of our surveillance personnel. The investing public also will report perceived improprieties in their own accounts or in the market in general. We also work closely with the SEC and other self-regulatory bodies such as the Intermarket Surveillance Group, which is composed of the New York Stock Exchange, NASD, regional and options exchanges in the U.S., and foreign SROs such as the London Stock Exchange and Euronext, which alert us to abuses that may occur in more than one marketplace.

Sophisticated technology and pattern recognition systems are used by the staff to detect and investigate activity that may violate NYSE rules or federal securities laws.   Such activity may involve:

• Insider trading
• Market manipulation
• Breaches of fiduciary duties
• Violation of agency responsibility and investor protection rules
• Failure by specialists to maintain fair and orderly markets in listed securities and products, and
• Violation of rules governing members’ on-Floor trading and auction market procedures.

Trading Surveillance

An integral part of the self-regulatory program of a market center is its surveillance of tarding activity. The trading floor is comprised of specialists, registered options traders, limited trading permit holders, member firm floor brokers, independent floor brokers, and their respective supporting staffs. The responsibility of ensuring that all trading activities effected by these floor members is in keeping with the rules of the SEC as well as the rules and policies of the exchange, falls within the purview of the Equities and Derivatives Trading Analysis departments. On-Floor trading and auction market procedures include creating exception reports to identify the following:

• Trade-Through;
• Locked Markets;
• Crossed Markets;
• Trading Ahead of customers;
• Prearranged trading;
• Wash trading;
• Shredding Orders;
• Money Passing;
• Counterparty trade percentages;
• Top order fishing;
• Marking the close;
• Error account;
• Transfer trade activity and
• Exchange transactions.

NFA also utilizes profiling of markets and individual traders to dynamically assess market participants trading patterns for unusual activity. In addition, the market surveillance process includes the monitoring of market activity in terms of price and volume and the monitoring of concentrations of ownership through large trader reports