Trade surveillance is facing significant challenges due to its traditional reliance on single venue monitoring and an over-reliance on the indicators of manipulative behaviour from the annexe to the ESMA guidance for MAR. Moreover, such frameworks lack compatibility with fundamental techniques in banks’ market-making and risk-management teams. The result is a trade surveillance industry ill-equipped to mitigate the risks of cross-product abuse and bearing the significant costs of an over-abundance of false positives. To address these issues, it is essential to examine the fundamental aspects of trade surveillance, including how banks' trading desks make money and the primary legislation governing market abuse.
Firstly let’s consider the question: How do trading desks make money? Looking at their business models and how they operate within financial markets day-to-day leads to an understanding of how traders can be capable of manipulation and abuse.
Banks typically offer both agency and principal trade execution services to their customers. Under an agency model, banks provide a means of execution for customers: they facilitate the trade execution without taking any market risk on the transaction themselves. They effectively buy or sell on behalf of their customers on a perfectly matched basis. This is not a high-margin business, instead, the customer pays a fee for the service provided. The model can be seen across different asset classes but is particularly prevalent in very liquid securities such as cash equities.
Alongside an agency model, banks also provide trade execution services for customers on a principal basis. Under this model, the market-maker will provide a ‘risk price’ to the customer, and if executed, the trader bears the market risk of the trade. Trading as principal is typically required where customers either need to trade a large size of a liquid security or any size of a less liquid security or derivative. The rationale here is that it is either impossible to source the risk for the customer on a perfectly matched basis or doing so would involve excessive execution costs (i.e., market impact).
Acting as principal to a trade also allows banks to offer customers exactly what they want in terms of a bespoke structure of a trade. For example, a customer may want to hedge the interest rate risk in a loan they are agreeing today, though it will drawdown in 3 months’ time, and then be repaid over time to create an amortising schedule. There is no standard existing product that perfectly hedges this risk. However, an interest rate swap trader is still able to structure a hedge that mirrors the profile of the loan and hedges the customer’s interest rate risk. However, in doing so, the trader will take on the bespoke market risk of the trade themself. They are compensated for this with a margin they receive on the trade, which will scale proportionally to the size and complexity of the market risk they take on and the illiquidity of that risk.
While banks are in the business of taking and warehousing risk, market-making businesses will generally look to hedge most of the market risk they take on when acting as principal. The question is, how do they manage this when hedging the risk on a perfectly matched basis is either impossible or unprofitable? The answer lies in the fundamental skill of being a principal market-maker: the ability to break risk down into its constituent parts and determine when and how to hedge them. This requires balancing the execution costs of hedging with the effects of running the market risk, using the margin the customer has paid as a buffer. Market-makers are able to manage this process while often trading with multiple customers in quick succession. They do this by using mathematical abstractions to understand the market risk they need to hedge instead of attempting to understand an often vast and constantly moving inventory at the security level. These abstractions are typically modelled as greeks, or sensitivity measures such as DV01 and CS01.
Hedging costs, or execution costs more generally, are typically a function of the security's liquidity. Thus, one way to minimise the cost of hedging idiosyncratic market risk is to use the most liquid product possible to hedge the required risk. So, in our example above where a trader has provided a customer with a hedge for the interest rate risk of a loan, the trader may use a combination of interest rate futures and bond futures to cheaply hedge the majority of the DV01 of the trade. This fungibility of risk across multiple products is a key concept for principal-based market-making businesses.
It is, therefore, clear that it is fundamental to the business model of principal market-making for traders to view market risk in terms of DV01s and CS01s, and to trade across a variety of securities, products and venues to manage that market risk. This should, in turn, shape an understanding of how a trader may abuse or manipulate financial markets. It is essential to consider that the trader may do so across multiple securities, products and venues, in line with how they operate in those markets daily as part of their core business model.
Having understood how traders operate in financial markets, consideration should be given to what the primary legislation has to say about trade surveillance. Read the next blog in this series here.