Securities regulators across the globe have demonstrated their willingness to investigate and prosecute market abuse in all asset classes, and fixed income is no exception.
Regulators, such as the Financial Conduct Authority (FCA) in the U.K. and the European Securities Markets Authority (ESMA), have recently called out fixed income as an asset class where firms need to focus their attention. Regulators want firms to ensure that monitoring takes the unique characteristics of the asset class into consideration. In addition, the FCA recently expressed its concern over the relatively low number of suspicious transaction reports for fixed income compared to exchange-traded products.
The feedback from regulators, coupled with recent prosecutions and large fines for market abuse in fixed income, demonstrates the need for firms to reexamine the effectiveness of their surveillance programs and update them to accommodate the nuances of the asset class.
In December 2019, France’s financial market regulator, AMF, fined a U.S. bank €20 million (about US$22.2 million) for manipulating the price of French and Belgian government bonds in June 2015. Over a 15-minute period, the European government bonds desk aggressively purchased French and German sovereign bond futures contracts and then immediately sold various cash bond issues on two electronic trading platforms.
That same month, the U.S. Commodity Futures Trading Commission charged an executive at a British bank with manipulating an interest rate swap price between a bond issuer and a global investment bank in 2012. The scheme, which was executed with the help of a trader he supervised and an interdealer broker, was designed to maximize the bank’s profit at the issuer’s expense by manipulating the prices of five-year basis swaps.
In April 2021, the EU imposed an antitrust fine of €28.5 million (about US$31.2 million) total on three banks from the U.S., France and Switzerland for taking part in a bond cartel. The scheme operated in the European secondary trading market related to U.S.-denominated supra-sovereign, sovereign and agency bonds. Traders at the four banks colluded on trading strategies, exchanged sensitive pricing information and coordinated on prices over five years via chatrooms on Bloomberg terminals.
Fixed income – an entirely different animal
Herein lies the challenge; many firms’ surveillance systems are often more attuned to exchange-traded products such as equities, where markets are centralized, and there is an abundance of order-book transparency and market data. Those assumptions are often transferred to fixed income surveillance and have throughout the years been built into the setup of many legacy fixed income monitoring services.
Fixed income requires a different approach since the market is highly concentrated, making it susceptible to collusive behavior among banks and primary dealers. It is also widely understood that market data may be opaque or patchy due to the vast number of liquidity providers and platforms.
There is another level of added complexity that comes from the “Request For Quote” mechanism. RFQs are a common price discovery mechanism, and it is vital for surveillance teams to monitor interactions for front running as traders move between clients’ requests and the dealer market. By not capturing this interplay between traders and clients, a firm becomes open to front-running risks and associated penalties.
Monitoring fixed income instruments on a “like to like” basis is half the battle. There is interplay between correlated instruments; cash instruments are highly correlated with their financial derivatives, the relationship between bond futures and cash bonds being one example. With this potential for cross-market manipulation, surveillance professionals must adapt strategies to include these risk scenarios.
Insider trading takes on a different form in the fixed income space where it is not necessarily driven by market news but rather by information garnered from client orders or RFQs. The information contained in these client requests can include market-moving information upon which entities can act in order to aggressively pre-hedge or front-run that information for financial gain.
Time for a review
There is no better time than now to review your firm’s current surveillance configurations to ensure they’re designed to capture the end-to-end trade lifecycle in fixed income securities and related products. As you go through that process, here are six best practices to consider:
- Incorporate Yield to Maturity (YTM) and modified duration into alerting metrics and visualizations. This allows you to view normalized bond trading data across a range of attributes and detect and identify volume or size anomalies. You can also identify yield/price outliers by overlaying trading in related bonds – those with the same issuer and similar maturity, for example.
- Incorporate DV01 into your data model and alerts. This data point is the most effective way to identify unusually large trade sizes and trading risks.
- Distinguish dealer-to-client flow from dealer-to-dealer flow because that allows you to better address risks by enabling alerts for the appropriate order and trade flows, which leads to an overall reduction in false positives.
- Integrate RFQ flows as well as dealer-to-client orders, and track these against dealer-to-dealer trading flows. This context helps detect client front running, where an entity subsequently trades in order to be positioned ahead of and take advantage of the client’s activity.
- Integrate a market data feed that sources data from venues, interdealer brokers and other intermediaries. You’ll be better equipped to identify trades that are priced significantly away from the evaluated price.
- Review your capabilities for linking related fixed income products across the cash markets and exchange-traded bond futures markets. The surveillance across price correlated products is a challenging area of surveillance. However, progress is being made in defining relatedness between bonds and futures and monitoring across those products.
For more information about how the Nasdaq Trade Surveillance solution can help you improve fixed income market monitoring, please contact us.