Manipulative trading practices: A guide for banks’ legal and compliance departments

How to recognise manipulative and deceptive trading practices

Types of market manipulation 

As acknowledged by the FCA in Mark Steward’s speech, “Market integrity and strategic approach” in February 2020, market manipulation cases are complex and more difficult to investigate than insider dealing or other types of market abuse (see FCA: Market integrity and strategic approach (7 February 2020)). This is often because they are orchestrated by a group of individuals in a sophisticated way, carrying out what may seem like standard transactions. These practices can occur over long periods of time and usually do not involve “opportunistic trading”. However, this only serves to underline the need for firms to have appropriate safeguards in place to identify and reduce the risk of market manipulation and to keep these under review.

The retained EU law version of the Market Abuse Regulation (596/2014) (UK MAR) prohibits actual and attempted market manipulation and such conduct may also constitute a criminal offence (including under sections 89 to 91 of the Financial Services Act 2012). Preventing, detecting and punishing market abuse, including market manipulation, remains a high priority for the FCA. For more information on MAR, see Practice notes, EU Market Abuse Regulation (EU MAR): overview and UK Market Abuse Regulation (UK MAR).

In the context of previous enforcement action, the FCA has indicated that there is a clear risk to market integrity and confidence if those who perform compliance oversight functions are not sufficiently able to identify clear warning signs of potential market abuse and that it is in the nature of compliance responsibilities that those who exercise them need to be able to respond to circumstances which are rare and unusual (see FCA: Final notice: Tariq Carrimjee (22 November 2016)). Those who fail adequately to discharge their responsibilities could face personal sanctions including being prohibited from performing controlled functions and being subject to a financial penalty.

Manipulative practices vary across different markets and instruments. It is therefore difficult to prescribe what makes a particular practice manipulative or deceptive. Indeed, sometimes trades are executed for legitimate purposes but may appear unusual and abusive, especially where the market is illiquid or volatile. The table below sets out a non-exhaustive list of examples of market manipulation behaviours from the FCA’s enforcement action in this area.

Indicators

Red flags for potential misconduct will depend on, among other things, the type of asset class, the type of trading in question and the features of the particular market. However, previous enforcement action has highlighted the following potential indicators of market manipulation. These indicators do not, in themselves, constitute market manipulation, but may be taken into account when transactions or orders to trade are investigated by the FCA:

• Unusual size of orders.
• Orders placed on the order book for an unusually short time period.
• Consistent buying interest at increasing prices regardless of market conditions (Winterflood).
• Orders at prices above the prevailing market price (Goenka).
• Entering orders to “buy high and sell low”. That is, entering orders to buy shares on one exchange at a certain price, while offering to sell the same security on another exchange at a lower price (Da Vinci).
• Using different systems to place orders on each side of the trade.
• Different strategies or levels of visibility for buy and sell orders (Abbattista).
• Orders representing a very high proportion of the orders placed in the market in relation to the shares in question (Da Vinci).
• Very close correlation between the placing of the orders by traders and the price movement of the instrument in question (Da Vinci).
• Placing orders in the last few seconds of an auction effectively ensuring little or no time for potential sellers to enter orders in response to buy orders (Goenka).
• High volume and frequency of rollover trades (Winterflood).
• Where a market has a small number of participants, two or more participants acting in concert to manipulate the price have the potential to have a greater impact than might otherwise be the case (Kerr, 2010).

Other red flags for market abuse more generally include using codes in communications, using personal communication channels for business matters and the deletion of specific messages or emails. UK MAR also sets out in Annex I indicators of manipulative behaviour. Annex I confirms that these indicators are non-exhaustive and again do not, in themselves, constitute market manipulation, but they are taken into account when transactions or orders to trade are investigated by the FCA.

Indicators relating to false or misleading signals and to price securing

Where the orders to trade or transactions:

• Represent a significant proportion of the daily volume of transactions, especially when it leads to a significant price change.
• Are undertaken by persons with a significant buying or selling position, leading to significant changes in price.
• Lead to no change in beneficial ownership.
• Include position reversals in a short period, represent a significant proportion of the daily volume of transactions and might be associated with significant changes in the price.
• Are concentrated within a short time span in the trading session and lead to a price change which is subsequently reversed.
• Change the representation of the best bid or offer prices and are removed before they are executed.
• Are undertaken at or around a specific time when reference prices, settlement prices and valuations are calculated and lead to price changes which have an effect on such prices and valuations.

For more information, see Practice notes, UK Market Abuse Regulation (UK MAR) and UK MAR: market manipulation.

Indicators relating to the employment of a fictitious device or any other form of deception or contrivance

When the orders to trade or transactions are undertaken by persons:

• And are preceded or followed by dissemination of false or misleading information by the same persons or by persons linked to them.
• Before or after the same persons or persons linked to them produce or disseminate investment recommendations which are erroneous, biased or demonstrably influenced by material interest.

Manual and automated processes

Sanctions apply regardless of whether the trading practice was carried out manually or through automated means. Although the FCA recognises the benefits of automated processes (for example, that algorithmic trading may be beneficial for market integrity by providing an important source of liquidity), it is clear that abusive strategies, whether via automated trading or otherwise, will not be tolerated (see FCA: Market Watch Issue 44 (August 2013)). In 2013, the FCA found an individual to have engaged in market abuse by deliberately manipulating commodities futures using an algorithmic “High Frequency” strategy, imposing on him a fine of nearly £600,000 .

Consequently, a firm’s monitoring and surveillance systems should be tailored to the specific risks within its algorithmic trading activity and suitable market abuse training should be conducted for all relevant members of staff (see FCA: Algorithmic Trading Compliance in Wholesale Markets (February 2018)). The FCA has flagged types of market manipulation which can be associated with algorithmic trading, including but not limited to “momentum ignition” (essentially creating a false market to benefit as it rebounds) (see FCA: Regulating High Frequency Trading (4 June 2014)) and “quote stuffing” (rapidly submitting and cancelling large orders to flood the market with quotes requiring processing by competitors, therefore ensuring that the competition loses its high frequency trading edge). For more information, see FCA: Occasional Paper No 29: Aggregate Market Quality Implications of Dark Trading (August 2017), page 9.

More generally, firms need to consider the potential impact that algorithmic trading activity (including the combined impact of multiple algorithmic strategies) may have on the fair and effective operation of financial markets, including at the development stage of any algorithms. For example, in its Market Watch 67, the FCA noted that its internal surveillance algorithms had identified trading by an algorithmic trading firm which raised potential concerns about the impact the algorithms responsible for executing the firm’s different trading strategies were having on the market. As a result of the FCA’s enquiries, the firm adjusted the relevant algorithm and its control framework to help avoid the firm’s activity having an undue influence on the market. See FCA: Market Watch 67 (28 May 2021).

Dealing with suspected market manipulation

Where possible market manipulation is suspected, firms should consider:

• Whether it is appropriate to conduct an initial fact-finding exercise internally to ascertain whether further investigation or regulatory notification may be required (taking into account whether any criminal activity may have occurred and considerations regarding preservation of evidence).
• If so, who is best placed to carry out this exercise (taking into account how the suspicion has arisen or been identified) and what steps should be taken.

The FCA may seek details of any fact-finding or internal investigation carried out by a firm and it is therefore important that these follow a clear and defensible methodology. Firms should consider taking legal advice including in relation to the creation of any written communications or other documents and the extent to which such materials may be privileged.

From a practical perspective, as part of any fact-finding exercise, it may be useful to:

• Ask open questions designed to obtain as much information as possible.
• Stress test explanations rather than accepting initial explanations at face value.
• Review emails, trading data and its patterns, and listen to tapes. Gathering all relevant pieces of evidence is crucial and can be challenging.
• Create a timeline of trading activity using the available data.
• Verify explanations against the available data and pose follow up questions where necessary in relation to any discrepancies.
• Where possible, seek assistance from those with first-hand experience and understanding of the relevant market (but who are not themselves potentially implicated).
• Seek to quantify any potential market impact (bearing in mind that practices can be manipulative even when trading in small volumes).
• Be mindful of any data privacy implications and other employment law considerations. For more information, see Data protection in employment under the UK GDPR and DPA 2018 toolkit.

In stress testing explanations, it may be useful to have regard to previous cases and the regulator’s view of explanations that were provided (while recognising that all cases must be assessed on their own particular facts).

Defences which have been raised, and rejected, in market manipulation cases include:

• Traders were simply making a market (Da Vinci). Market-making involves quoting on both sides (sell and buy) of the marketplace. The function of a market-maker is to provide liquidity to the market by standing ready to fulfil both buy and sell orders and as such they must maintain continuous two-sided quotes. In Da Vinci, the court held that the defendants did not maintain continuous two-sided quotes and their practice was to place orders predominantly on one side of the book, moving orders from one side to the other in a “saw-tooth” pattern consistent with trading conduct intended to influence demand and supply and therefore price. The court concluded that they were not acting as genuine market makers.
• Legitimate long-term investment strategy (Chaligné). In Chaligné, the argument that Mr Chaligné was combatting downward pressure in a difficult and volatile bear market by trying to support the prices, not to increase them to their maximum possible level, was unsuccessful. The Upper Tribunal’s view was that, even if Mr Chaligné genuinely thought the prices of the stocks needed to be “shored up”, his claimed strategy for doing so (whether or not it amounted to market abuse) made little sense because it was likely to be financially disadvantageous for him.
• Misunderstanding. For example, a misunderstanding that led to instructions that traders buy stocks more aggressively than intended (Chaligné). In Chaligné, the evidence did not support the argument that there had been a misunderstanding. This defence was rejected on the strength of, among other things, the transcripts of telephone conversations which showed that at no point did Mr Chaligné express any misgivings about the strategy of placing orders at increasingly higher prices and of doing so near to the close of the markets.
• Being unaware that what they were doing was wrong (Da Vinci). In Da Vinci, the court found that the individuals involved were experienced traders who had had previous association with Swift Trade (which was fined for layering in 2014). The court concluded that they must have been aware that spoofing and layering was improper.

While preserving confidentiality, it is important for the investigation team (which may include the compliance department; carefully selected and non-conflicted senior front office employees; senior management; and legal (including employment lawyers)) to work in a co-ordinated manner. It may be appropriate to consider:

1. filing a suspicious transaction and order report (STOR) in accordance with MAR requirements. For more information, see Practice note, UK MAR: suspicious transaction and order report (STOR) regime; or
2. making a Principle 11/ SUP 15 notification.

When conducting internal investigations into potential market manipulation, in addition to their regulatory position, firms should also be mindful of their employment law position vis-à-vis relevant traders and other employees, and take into account whether legal requirements in other jurisdictions may be relevant (for example, from an employment or data protection perspective). Firms have previously been faced with employment proceedings in connection with an internal investigation process.

Policies, procedures and controls

Firms’ surveillance arrangements, systems and procedures regarding market manipulation must be appropriate and proportionate to the scale and nature of each firm’s own business activity. To this end, the FCA has highlighted the need for firms to undertake a proper assessment of their business, the risks that could arise as a result and the systems and controls which are suitable to mitigate those risks (see FCA: “Market abuse requires a dynamic response to a changing risk profile” (May 2019)). It is the responsibility of each firm to make its own judgments about alert calibration. Firms risk failing to comply with their regulatory obligations if they assume that a certain calibration is appropriate on the basis that it is appropriate for their peers (see FCA: Market Watch Issue 56 (September 2018)).

When considering potentially abusive behaviours and the precautions that should be put in place, firms should also use internal knowledge from a variety of sources including their front office functions, who are closest to the risks (see FIA report: Surveillance and Market Practices (September 2020)).

Robust measures, controls and procedures may include:

• Regular updates to policies and procedures to ensure that guidance is clear, including in relation to the escalation of any suspicious activity.
• A systematic approach to risk assessments, which are properly documented and repeated annually or when another trigger occurs. This may mean that firms need to invest in more sophisticated and automatic surveillance tools.
• Pre-trade controls to prevent the entry of orders that exceed credit limits or appropriate price or size parameters.
• Alerts generated through surveillance arrangements being evaluated by appropriate independent individuals in a timely manner and in conjunction with other relevant contextual data (for example, information regarding near-misses) and through discussions with traders and trading management where appropriate (providing no conflicts of interest).
• An appropriate written methodology for investigating alerts, as well as appropriate levels of sign off for the closure of alerts and proportionate sample testing of alerts and escalations.
• Supervisory controls and procedures that address the creation, modification, usage and testing of trading algorithms for manipulative, deceptive or suspect trading practices.
• Sufficient trader login and access procedures.
• Bespoke market conduct training provided on a risk-based approach with real life examples or case studies, which is annually assessed to ensure that it remains appropriate.
• Adoption of appropriate incentives and evaluation of employees’ commitment to compliance in promotion and compensation decisions.

Firms must have adequate systems in place so that they are able to comply with their regulatory obligations at all times, including if there are changes to a firm’s business model. Market participants should refine controls continuously as external factors, such as new products or customers, may require systems and controls enhancements (see FIA report: Surveillance and Market Practices (September 2020)).

The FCA has taken enforcement action in connection with failures to take reasonable care to organise and control affairs responsibly and effectively with adequate risk management systems in relation to the detection and reporting of potential instances of market abuse. Particular failings have included:

• Failing to arrange suitable alternative surveillance where automated alerts had been disabled.
• Having identified the risk of market abuse in an affiliate or group entity, failing to map that risk across the business and adequately address it.
• Lack of formal senior management board and committee structure to facilitate compliance and conduct risks, including the risk of market manipulation, being properly considered.