The Financial Industry Regulatory Authority has begun to implement a new set of computer programs that watch for illicit trading patterns across national exchanges, dark pools and brokers’ internal pools of orders, as well as alternative trading systems.
FINRA is broadening its surveillance in two ways: the number of markets it can and will watch at the same time, with each pattern; and its ability to watch multiple trading firms, at the same time, that may be acting in concert.
In effect, the independent regulator of brokers can now keep track of the actions of multiple parties working across multiple markets at the same time.
FINRA says it will use rigorously tested programs to watch for patterns of behavior across markets and trading firms-patterns that indicate questionable activity is taking place.
“We have introduced a suite of cross-market surveillance patterns that canvasses the 80 percent of the listed equity markets that FINRA regulates in a holistic way, which includes trades internalized at broker dealers, alternative trading systems and dark pools,” said Thomas Gira, executive vice president and head of market regulation at FINRA. “Across the board, we are going to be looking for questionable conduct. Some of that could be in dark pools. Some of that could be on exchanges.”
In effect, where FINRA had multiple, similar patterns looking for the same conduct on different markets, it will now be able to use a single program to look for a given pattern across all markets, he said.
The surveillance will cover 1 billion order events being generated daily by venues that include exchanges operated by Nasdaq OMX Group and NYSE Euronext, as well as the dark pools, broker’s internal pools and alternative trading systems that make up the over-the-counter equities markets, Gira said. Exchanges operated by BATS Global Markets and Direct Edge are not under FINRA’s watch and won’t be part of the surveillance.
“The bad news is, 20 percent of the market is missing,” said Howard Tai, senior analyst at industry consulting firm Aite Group. “The good news is, 80 percent is there.”
BATS and Direct Edge operate all-electronic exchanges that largely cater to algorithmically driven customers, using complex, high-speed trading strategies.
See Sidebar: What FINRA Is Looking For
“They might have a higher success ratio, if you could include those two,” said Howard Tai. Nonetheless, he said, “it’s a start. It’s the right start.”
Among the patterns FINRA will be looking for are matched orders to buy and sell shares of a stock that create the false appearance of market activity, generally called “wash sales,” as well as “momentum ignition” strategies such as layering, spoofing and marking the close.
“We are looking for abusive strategies where people, or more accurately computers programmed by people, are trying to ignite momentum in the marketplace to take advantage of that ignition,” Gira said.
“All of these strategies can be achieved by spreading activity out across multiple trading venues,” he said. “The value of our new cross-market patterns is that, even though the markets are fragmented, all the data is coming into one place; we have 80 percent of it, and we can see patterns as they occur across all the markets.”
The effect on institutional trading might be small. “You’re talking about friction at the margin,” said Marc Chaikin, founder of Chaikin Analytics, which provides quantitative tools for analyzing stock movements to large money managers.
Most sophisticated shops can filter out the “momentum ignition” activity, Chaikin contends.
“I’m not sure the end result is hurting anybody,” he said. Goldman Sachs, which runs the biggest trading desk for institutions, “is not doing this.”
The data come from FINRA’s Order Audit Trail System, which takes in order, quote and trade information for stocks. FINRA requires its member brokers to report order information for all National Market System stocks and over-the-counter equity securities to the system. Last year, the New York Stock Exchange shut off its order tracking system and began sending data from its markets to OATS.
The data do not include quote or order information from the four all-electronic venues operated by national exchange operators BATS Global Markets and Direct Edge.
OATS has also been suggested as a possible foundation for the consolidated audit trail of options and equities trades the Securities and Exchange Commission has ordered FINRA and all exchanges to create. A plan for that is due April 26, but the industry has asked for an extension to December.
As with the programs created by high-speed trading firms, FINRA says it will be testing its surveillance patterns rigorously, before deploying them.
“There is exhaustive testing that goes on before we launch a pattern to make sure it detects what we intend to capture,” out of the billion events a day that it will be watching, Gira said.
What FINRA Will Be Looking For
In particular, the Financial Industry Regulatory Authority will be looking for trading patterns that try to create the false impression that there is “momentum” in a stock. Among the practices-conducted by individual traders and individual firms, but also in arrangements between multiple traders and multiple firms-are layering, spoofing and “marking the close” programs.
Here’s how these work:
Layering: This is where trading firm or firms send out waves of false orders intended to give the impression that the market for shares of a particular security at that moment is deep. The traders then take advantage of the market’s reaction to the layering of orders.
Spoofing: The trader or traders involved will send out an order with a corresponding cancellation, often at the opening or close of the market, in order to get a particular market reaction.
Marking the close: A firm or firms can have a sell order execute at the end of the day and exhibit aggressive buying behavior in the run-up, to drive up a stock’s price, said Thomas Gira, executive vice president and head of market regulation at FINRA.
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