StarCompliance: Insider Trading Detection Needs to Evolve Beyond Rules-Based Compliance

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Will Haggerty is the director of product management at StarCompliance. He has 10 years of experience in the financial services industry ranging from investment analysis and technical consulting to risk management and sales. Here he shares his thoughts on how insider trading detection needs to evolve beyond rules-based compliance.

FINRA recently found that a Goldman Sachs research analyst had been violating insider trading regulations by trading with material non-public information. He is also accused of lying to FINRA investigators about his undisclosed brokerage accounts and history of trading securities of companies that his business unit covered. FINRA banned him from trading securities, and the conviction seriously scarred Goldman Sachs’ reputation.

Of course, the SEC requires financial institutions to prevent insider trading like this — but it does not outline concrete guidelines for doing so. As a result, compliance teams have typically relied on employee disclosure in a rules-based approach. The problem? Employees are unlikely to report their own nefarious activity.

The Downfall of Rules-Based Compliance

While some critics are quick to blame Goldman Sachs for letting illegal trading happen under the company’s watchful eye, the truth is that there’s no way the firm could have known about the activity. Like most other financial criminals, the individual in question sagely elected to place trades in an account of which the bank was not aware and thus hadn’t included in its employee monitoring measures. Insider trading is seen as uncommon not because it isn’t happening but because spotting it and convicting it remains largely dependent on the perpetrators reporting themselves.

Banks rely on disclosure for rules-based compliance, meaning they ask employees to disclose their accounts and trades and then cross-reference this information with data compiled with compliance technology. Some brokers will disclose new accounts to an employer if an account holder has indicated they work in the securities industry. Still, an employee could open a new online brokerage account without indicating their position as a financial professional and effectively circumvent these enforcement measures in one fell swoop.

Essentially, insider trading is happening — but policies for policing it will continue to be inadequate if they rely primarily on employee disclosure. Encrypted communication apps make it hard to track down connections involved with insider trading, and nearly anyone can open an account and begin trading quickly from their phones. The methods of communicating and the ease of opening accounts to trade in are concerning, and firms must transcend the rules-based compliance approach to identify high-risk situations, investigate them efficiently, and take necessary action before regulators do.

The Intersection of Employee Behavior and Market Movements

Some rules-based compliance measures are necessary for preventing insider trading, but it’s important to remember that they’re just the first step. For example, the convicted Goldman Sachs analyst was trading off MNPI that a fellow analyst produced. While the perpetrator was an analyst, he could have just as easily been an IT person who had access to internal emails. Information barriers that control the flow of MNPI and keep it out of the wrong hands are a vital first line of defence against insider trading. Compliance teams should monitor and investigate the flow of information daily, if possible — and weekly at minimum. Monitoring is most effective when it turns up evidence as soon as possible instead of 30, 45, or even 90 days outside of the illegal activity.

Next, compliance teams must define what “suspicious” activity means for their organisations and monitor for those activities. Was there a change in price shortly before or after a trade that was favourable to the employee? People often think of insider trading as a means to make money, but it can also be a means to avoid a sizable loss. Trading volume is another key consideration, and employees might use MNPI to establish a position in advance of a large amount of public interest in a company.

Monitoring the flow of information and spotting suspicious activity are necessary measures. However, on their own, they can cloud true signals of insider trading because they lack the context of the broader market. To transcend rules-based compliance, firms must establish methods of detecting insider trading whether employees self-disclose or not.

Compliance teams need a way to match employee behaviour with market movements to uncover meaningful insights beyond employee disclosure. They can start with a tool that allows for gathering and collating all employee behavioural data, such as trading in new spaces and seeing significant gains or avoiding losses. Then, they must analyse this data against the broader market context to uncover potentially telling patterns and trends. Essentially, a firm’s ability to surface instances of insider trading before regulators do will come down to compliance teams’ abilities to collect behavioural data and analyse it broadly.

https://thefintechtimes.com/starcompliance-insider-trading-detection-needs-to-evolve-beyond-rules-based-compliance/