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Catching the Insiders

Catching the Insiders

November 23, 2010 0 Comments

Dr. John BatesThe FBI has raided some heavy hitters this week (http://tinyurl.com/238hrph), with three well-known hedge funds getting their doors rammed in, figuratively speaking. This could be the tip of the iceberg in all-encompassing insider trading investigation involving research firms, investment bankers, hedge funds and mutual funds. The gist of the investigation is that some trading firms might have been using sensitive market information provided to them by research firms before the market got it.

Traders have long sought out information that can give them an edge over a deal. But there is a fine line between giving trading tips and offering up non-public information to trading firms. One is legal, the other - of course - isn't. Whether these cases prove to be valid or not, there must have been clear evidence that insider information was used. Trading patterns can provide clues to insider activity, particularly if more than one firm acts in the same manner at the same time on the same information - prior to the market reacting. If the FBI can see these trading patterns it can then go after the participants to confirm suspicions. Traditionally this means recording of phone calls, emails and messaging conversations.

An example of a pattern that might indicate insider activity is if a firm trades an unusually large amount of a particular instrument that they haven’t traded before, just seconds prior to a major news article that moves the market in that instrument. Maybe such a circumstance might just be good fortune or a result of good intuition, but a series of such occurrences from the same firm might be worth looking into. Upon further investigation you could find that several firms are doing this at the same time. Furthermore, perhaps the extent of the purchases is hidden across multiple liquidity pools. A whole pattern of evidence might be out there – under your very nose.

The problem with finding such a pattern of evidence is that many of the current methods of detection and investigation can only address the problem weeks, months or even years after they occur – if they can see it at all. Trying to sniff out insider trading without modern monitoring technology is like swimming after a shark. The shark ducks and dives and goes a thousand times faster than you can, eventually turning around and eating you.

To truly address the problem of insider trading, real time market surveillance technology must be adopted to monitor and detect patterns that indicate potential market abuse. The detection of abusive patterns must happen in real-time – so the authorities can respond while the iron is hot. Trading occurs at lightning speed these days, thanks to electronic and algorithmic trading. What has not kept pace in many cases is the use of monitoring technology necessary to stay on top of possible market abuses. As well as the use of technology by the authorities to help detect insider rings, exchanges, ECNs, brokers, traders and regulators all should take an intelligent approach to monitoring and surveillance in order to prevent other abuse and problems in their own domains – such as rogue trades - and fat finger errors.

Technology can't solve all of the problems, but it can offer more market transparency where issues can be identified much more quickly and potentially even prevented.



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