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Trading Room Misconduct and the Cost/Benefit of Prevention - Graham A.D. Broyd

Graham A.D. Broyd
New Coordinates
Spring 2017

Change is in the air, with the global financial crisis now nine years behind us and a new US President promising to overhaul bank regulation. Not so, however, in the area of bank conduct. The fines just keep coming for misconduct in foreign exchange (FX), derivatives, interest rate benchmarks, government and mortgage-backed securities and other areas of activity on banks' trading floors. Meanwhile, bank investment in preventing misconduct continues to fall short. But the prevention-to-failure cost ratio is now so striking, with the frequency of enforcement actions so high, that further consideration is warranted. Trading floor automation can help in some areas, but actually raises new issues in other areas.

Here is the picture today: Fines for misconduct since the crisis have now cost banks a staggering $321 billion, still growing faster than ever in 2016 (another $42 billion). The largest component of these fines continues to be failings related to activities on banks' trading floors. Not just mortgage-backed securities or LIBOR, but continued FX, fixed income, and derivative-related misconduct that caused a regulator to step in with enforcement action. What is more, a fine is only the start of the costs. Litigation often follows (usually from banks' own clients), and the remediation projects to ensure that bad trading room behavior does not recur can go on for years.

While some of this multibillion-dollar mountain of investigations, penalties, and related costs is for activities of the past, recent fines do not relate only to pre-financial crisis trades Misconduct is now ever closer in the rearview mirror, showing that lessons still have not been learned.

Bankers' reluctance to spend on prevention is understandable. They have had to spend very significant a mounts to implement a II the post-financial crisis regulatory agenda: the Basel Committee regulations on Capital and Liquidity, Dodd-Frank Reform Act, Volcker Rule, and Markets in Financial Instruments Directive (MiFID) have required lengthy, costly, and sometimes frustrating compliance efforts. But with much of that work nearing completion, and some regulatory easing on the horizon, there is some light at the end of the tunnel. Related compliance costs could drop off-to be reinvested in the business or just help revenues fall more cleanly to the bottom line.

A good argument could be made for reinvesting some of that money in prevention strategies. Prevention is particularly important if you were not a bank fined in the first round of FX and derivatives enforcements. It is always possible that your bank has had none of the same poor behavior, but these markets are all intertwined, activities are between counterparties, personnel shift from bank to bank during their careers, and practices--bad ones--have become embedded. Everyone in banking has seen the graphic media accounts on poor conduct and the resultant financial and reputational damage.

The Evolution of Misconduct

Some of today's misconduct failings are the same as ever: collusion with other banks to the detriment of the client; lack of transparency in pricing; excessive, inappropriate spreads; duplication of commission and spread income; and sharing of confidential client information. Yet some of the trading room conduct issues have evolved. Banks previously had to deal with a "bad actor" or a "rogue trader"-in other words, an individual involved in wrongdoing, identified too late. A bank could claim this was an outlier activity, terminate the offender, enhance its controls and culture, and move on. This human conduct risk can be mitigated by putting most trading and sales activity over automated, electronic systems.

Even as automation solves some conduct issues, it can raise others. Recent reports on trading room litigation and fines has included such terms as "last look," "spoofing," "front-running," and "vacuuming." These activities could be embedded in automated pricing systems, which have sophisticated technology, coding, and mathematical algorithms supporting straight-through processing of trades. These systems will be under the supervision not only of the trading manager but will have been supported by the operations, technology, risk, and compliance managers. They may now be pricing 85 percent or more of the activity on a trading floor. Any potential misconduct will be more subtle, but could now be considered institutionalized.

Reading Across Activities, Preventing Misconduct
An identified wrongdoing in one area of a bank's trading floor-say FX-is identified, investigated, penalized, and remediated-usually with some urgency and focus. Yet a while later the same issue (sometimes called by a different name) occurs with their interest rate derivatives products, or in their government securities business. Banks need to improve their ability to read across their business lines to identify and remediate similar issues. Otherwise, regulators' impatience will only mount, and litigation defenses could weaken.

How does one then effect a prevention strategy? Steps could include:
   
Get up to date with recent fines and enforcement, to see if they could apply to your business.
Implement a Strengths, Weaknesses, Opportunities, Threats (SWOT) analysis to do a read-across of already identified failings in trading activities.
Evaluate your trade surveillance capabilities-could you find the misconduct with your present capabilities?
Do a compliance gap analysis.

Regulatory enforcement actions nearly always require a remediation of broad compliance capabilities, to ensure the same mistakes do not happen again. Although always specific to a bank's particular case, regulatory expectations are usually very similar, following a continuum that includes the following questions:

First, does the bank understand the regulator's expectations?
Has the bank applied the regulatory requirements?
Does it have policies that match those requirements?
Does it have operating procedures that deliver the policies?
Does it have controls to monitor the procedures?
Does it have managers who will supervise the controls?
Does the bank have an effective compliance function-with resources, testing, controls, and surveillance?
Is the internal audit team empowered and reviewing?
What is the incentive structure for traders and salespeople?
Is there a governance structure in place around these activities?
Is there a supportive culture?

Banks do not have to wait for regulators; they should ask themselves these same questions. Prevention is never an urgent issue, until it is too late. Try it. 

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