By Dr. Giles Nelson, Deputy Chief Technology Officer (CTO), Progress Software
Follow Giles on Twitter

The definition of a rogue trader has changed dramatically over the past few decades, and the methods of catching one have changed as well. 

In the 1960s a very successful con man passed US$2.5 million worth of forged checks across 26 countries over five years. Frank Abagnale (played by Leonardo DiCaprio in the 2002 film "Catch Me if You Can") was the quintessential rogue trader, who claimed to have assumed no fewer than eight separate identities, including an airline pilot, a doctor, a prison inspector and a lawyer. He managed to escape from police custody two times and, despite being pursued for five years by the FBI and Interpol, was finally captured when a stewardess he had dated recognized him and turned him into the French police. 

Today when we talk about “rogue” traders we mean something entirely different. Rogue trading can be described as an individual or a group of traders deliberately trying to subvert or manipulate a market for an unfair gain. The gains that can be made far surpass Frank Abagnale's five-year $2.5 million spree, and they can happen over the course of weeks, days, or even milliseconds. 

Rogue trading can take many forms but the one that is receiving particular attention at the moment is the deliberate manipulation of investment pricing using electronic trading. This is important because the fear and misunderstanding around market manipulation poses as much as a threat to the markets as the market manipulation itself.

Let’s start with a couple of examples of deliberate market manipulation. First, there is front-running. This is where a broker places its own, proprietary, orders in the market ahead of a known client order. The broker, knowing what its client is going to do, can make a risk-free profit. Another example is pre-arranged trading, where two trading parties agree on a certain time to buy and sell an instrument. This gives a false impression of demand and may therefore affect the instrument price.

When a rogue is not a rogue

Many other types of trading are often put into the “rogue trading” bucket so it’s important to point out what is not rogue trading. High frequency trading (HFT), the use of technology to monitor and submit orders to markets extremely quickly, has been receiving a lot of bad press recently and is sometimes described as “abusive.” But it is no more abusive than two traders arranging a trade over the telephone. Yes, it can be used for rogue trading, but so can any other technology.

Similarly, algorithmic trading is seen by some as an industry curse. Recently, Credit Suisse was fined by an exchange after its algorithmic trading system went out of control and bombarded the exchange with hundreds of thousands of erroneous orders. But this wasn’t a deliberate attempt to manipulate the market. It was a mistake, albeit a careless one; there weren’t proper controls in place to protect the market from what, ultimately, was human error – the algorithms hadn’t been tested sufficiently.

Algorithmic trading and high frequency trading have enormous benefits – greater efficiencies for traders, more market liquidity, tighter spreads and better prices for all. To lose these benefits because of perception would be very dangerous. 

What isn’t in doubt is that new technology has made the markets faster and more complex. All market participants need to up their game to ensure that markets operate correctly.

Too little, too late

There have been significant changes to the way that markets operate. Total order volumes have increased and order sizes have dropped. According to recent research commissioned by the Financial Times, order sizes on exchanges globally have dropped on average by half over the last 5 years. Combined with great total order volumes this means that there is more activity on markets and they move much faster.

It is vital for exchanges and regulators to not only monitor the markets for rogue trader behavior, but to do it in real-time. That way, they can react more quickly, in principle actually preventing the rogue trading behavior. In addition, newer surveillance technology can allow regulators and exchanges to keep up with new rogue trading methods more effectively. Business intelligence and event processing technologies are now being deployed together to give greater research and analysis capabilities.

The proliferation of trading venues and dark pools gives further opportunity to rogue traders and more challenges to market regulators. Take the situation in European equities post MiFiD, which enabled the creation of alternative liquidity venues. Prior to this, liquidity was concentrated in national exchanges. Now, brokers may route an order from a client to many venues. In fact, the order may be broken down into multiple parts with each part sent to a different venue. So a nationally-based exchange or regulator just doesn’t have the full picture any more. The banks and brokers are having to take more responsibility for monitoring order flow which goes to the market via them and order flow from their own, proprietary, trading activities. Pressure is being exerted by regulators right now for them to have a continual real-time view so they know exactly what’s going on at any moment.

Bringing confidence to the markets

Confidence in the fairness of markets is being tested. A mixture of general post credit-crunch mistrust, rapid and misunderstood technological innovation, bad press and continued reports of rogue traders has created a mood of distrust. Two paths are open. The first is for governments and regulators to introduce draconian rules to try and prevent “bad trading behavior.” This may inevitably mean, with sentiment as it is, a clamp-down on high frequency and algorithmic trading resulting in many of the aforementioned benefits of such being lost. It will also mean that rogue traders will be in a better position to use the plethora of rules to better manipulate situations abusively for their own ends. The second course, and a far better one in my opinion, is for regulators to further ensure transparency and openness in markets. The key to this is technology. High frequency markets require high frequency, real-time, monitoring and surveillance.

The good news is that the technology does exist. Real-time surveillance software from companies like Progress Software can analyse data transactions by the millisecond in real-time. This technology is being deployed in trading rooms, exchanges, and by regulators such as the FSA. These solutions monitor trading activity in real-time and can detect instances of market abuse immediately.