Until recently, the focus on monitoring market abuse has been applied almost exclusively to trading in the secondary markets. This is the space where vendors have focused their attention and where the biggest, most eye-catching fines and prison sentences have been levied by regulators and prosecutors.
However, over the last couple of years, there has been a notable series of important regulatory complaints and prosecutions brought against alleged market abuse related to the primary markets. These have not received the attention that they merit either from the vendor community or the surveillance teams in financial institutions; we believe that this needs to be addressed.
In this series, we will focus on four such cases and demonstrate why there are significant risks in this arena and why surveillance teams need to concern themselves with the detection of abuse in the primary market space.
Primary vs Secondary Markets
At the risk of stating the obvious, let’s be clear about what we mean by primary and secondary markets.
The term “capital market” refers to any part of the financial system that raises capital from bonds, shares, and other investments. New stocks and bonds are created and sold to investors in the primary capital market, while investors trade securities in the secondary capital market.
As such, secondary market transactions involve the day-today trading of stocks, bonds, futures, commodities, FX, and OTC derivatives. These can be traded on a variety of venues (including exchanges) and/or over the counter.
Primary market transactions involve issuing new shares or bonds to raise funds for companies, governments, and public sector institutions. When these shares or bonds are first sold to the public markets, the issuer will often simultaneously enter into other trades, such as bespoke interest rate swaps or structured FX trades, with the bank leading the transaction. For example, interest rate swaps may be used to hedge the interest rate risk related to debt servicing costs, whilst a foreign exchange transaction may be required when using the funds to acquire an asset in a cross-border transaction.
Until now, the case studies that we have presented have involved manipulation solely in the secondary markets consisting of:
- U.S. Department of Justice vs. NatWest Markets Plc – Spoofing in US Treasuries.
- Commodity Futures Trading Commission (CFTC); U.S Department of Justice vs. JP Morgan Chase & Co. - Spoofing in Treasuries and Precious Metal Futures.
- U.S. Department of Justice vs. Deutsche Bank Securities Inc - Spoofing in US Treasury and Eurodollar Futures.
These case studies have typically involved single traders or a small group of traders acting alone to generate profits for their trading book or speed up the recycling of risk.
The nature of most trading mandates is typically that a trader works alone (or as part of a small team) and their activity is isolated to themselves or their group (desk). There is usually relatively little overlap between desks and individuals rarely act in concert, as a result of their individual mandates.
Primary market transactions are very different. In the example of a deal driven by takeover activity, such business can involve series of transactions bringing together many parts of the bank and several trading desks. For example, Bank XYZ advises on the acquisition of a European-based company by a US company. Such a transaction could incorporate:
- The M&A activity itself (generating large fees to the Investment Banking Team).
- Loans or credit facilities (Banking Team).
- Public equity issuance (Equity Capital Markets).
- Debt issuance (Debt Capital Markets).
- Structured and/or deal contingent interest rate swaps (various trading desks within a FICC business).
- Structured and/or deal contingent foreign exchange (FX Business).
Even relatively straightforward fixed rate bond issuance will often involve an interest rate swap used to convert the fixed rate coupons that the client is paying into a more convenient floating rate. Such swaps can be extremely large in size and, whilst bespoke and therefore unique, will need to be hedged using a combination of standard, secondary market derivatives and securities.
The price at which the bank trades these bespoke derivatives will often be determined by reference to the screen price of the liquid, secondary market hedge instruments at a particular time. If this screen price can be manipulated by the trader, additional profits will arise; potentially a profit which exceeds the fee for leading the primary market offering. As such, the traders involved in our case studies have manipulated, or are alleged to have manipulated, prices in the public markets in order to create additional profit when they enter into the private (primary market) derivatives.
The nature of primary market deals (and the potential rewards) means that winning such mandates requires a coordinated effort across many departments and will often include the client meeting extremely senior managers in the bank. If the transaction is important enough, the bank CEO may even meet the prospective client. Any abuse that arises in such a transaction can, therefore, produce enormous reputational damage to the institution and, via legislation such as the FCA Senior Managers Regime in the UK, present acute risks and personal liability to everyone involved.
Manager Personal Liability
Whilst there is not a direct equivalent to the FCA’s Senior Managers and Certification Regime in the US, the legal standards are broadly the same for “corporate officers” or “controlling persons”. Under the Supreme Court-created Responsible Corporate Officer doctrine, a corporate officer may be found criminally liable for regulatory offences even when he or she is unaware of and not involved in the wrongdoing if he or she is in a position of authority regarding the activities giving rise to the illegal conduct and failed to prevent or correct the conduct.
Additionally, both the Securities Act and the Exchange Act impose secondary liability on “controlling persons” for violations of securities laws committed by persons under their control. Generally, “control” for these purposes is held by any officer, director, or employee of a public company who possesses, directly or indirectly, the power to “direct or cause the direction of the management and policies” of the person or entity that is liable for a violation of the securities laws. Section 15 of the Securities Act provides that any person who controls another person who commits a violation under Sections 11 or 12 of the Securities Act will be jointly and severally liable for the wrongful conduct “unless the controlling person had no knowledge of or reasonable ground to believe in the existence of facts by reason of which the liability of the controlled person is alleged to exist.”
Section 20(a) of the Exchange Act provides that every person who indirectly or directly controls another person found liable for a securities violation under the Exchange Act is jointly and severally liable for that same conduct, “unless the controlling person acted in good faith and did not directly or indirectly induce” the act(s) constituting the violation. Originally, circuit courts were divided on whether the SEC had statutory authority to bring claims under Section 20(a). The Dodd-Frank Act clarified any confusion by amending Section 20(a) to grant clear authority to the SEC to bring monetary and injunctive claims against corporate officers and directors for violations committed by their subordinates.
Temptation
The derivative transactions that primary market activity presents are often huge. The Westpac case study involves the largest interest rate swap in the history of the Australian market (AUD 12bn). Contingent FX transactions have exceeded USD 40bn in size.
The price of such a transaction is often agreed by reference to a screen quote for a liquid (benchmark) instrument, either when the primary transaction is completed or following a call from the client.
Let’s consider the example of a deal contingent FX forward. This is an FX forward trade which is settled when and if a related M&A transaction is completed. If the M&A transaction does not complete, the FX forward is cancelled at no cost to
the customer. As stated above, such transactions can be huge and have exceeded USD 40bn.
In such a transaction, the price might be set as the price quoted on a particular broker screen plus potentially 0.75 cents. So, if the screen quoted 1.2700 then the transaction would be done at a price of 1.2775. As a guide to the sheer scale of these transactions, in the case of a USD 40bn deal related forward, a price movement of a single pip (i.e., a shift from 1.2700 to 1.2701) would result in a profit of over USD 3,000,000. Given the potential rewards of influencing that screen price, the temptation to trade ahead of the fixing must be extremely strong. The first four case studies that we will present show cases where traders gave in to (or allegedly gave into) that temptation.
Case Studies
Through the case studies, we will discuss the economics behind primary market and M&A driven transactions and how they create opportunities for bad actors to manipulate markets and the blind spots that exist within surveillance solutions. We
will dissect four recent enforcement actions and outline why approaching this issue through a risk-based lens offers the only meaningful way to manage the problem.
The case studies are:
- ASIC vs Westpac – Case pending April 2024 – Alleged pre-positioning ahead of a series of interest rate swap transactions to support a prestige transaction, a partial privatisation of NSW’s national grid.
- CFTC v Mizuho Americas April 2023 – Deal Contingent FX Forwards – Manipulation took place on the screen price.
- CFTC vs HSBC – April 2023 – Manipulating swap spreads on screen to influence the pricing of issuer swaps.
- CFTC vs John Patrick Gorman III - Alleged manipulation of the pricing of issuer swap.
All four case studies are available to download here.