Compliance in the trading world is more a topic for frequent discussion than proactive action. In case of investment banks, which significantly influence industry behavior, compliance is viewed more as a back-office function and hence, a cost centre. And when compared to profit centres such as frontline SBUs, the reputation of this function is a dampener for growth.
Though not publicly accepted, investment banks view many regulatory initiatives with apathy - just do what is required. Complying with the letter is more important than the spirit. In fact, if the front-office focuses on building flexible, real-time systems which are in line with stringent norms of microsecond advantage using superior process definition, technology and talent, regulatory compliance applications are built using batch processing legacy technologies. And the development team considers such assignments more as punishment posting than an elevation. In essence, effort is directed more towards 'complying'.
Although trading is supervised well from the perspective of 'front running' and helping their counter-party trader (prevalent in bond trading desks) within the investment banking, less has been achieved on employees' personal trading for a set of assets classes or individual securities. Over the years, there has been little progress on building a proactive mechanism of monitoring, reporting and possibly restricting personal trading. One reason is that monitoring personal trading significantly depends on manual processes such as paper submission using spreadsheets and investment banks lack the wherewithal to file personal trading details during an audit process. Where it exists, the process of filing external regulatory reports on employee personal trading is riddled with delays and inaccurate data attributes.
Within investment banks, employee personal trading falls under two categories - noncore and privileged. Noncore employees may not have access to privileged information and may fall in the outer layer. Privileged employees have privileged access to information related to the material interest of the bank. Such information has leveraging potential from the personal gain perspective. And while there are laws in place to closely monitor these conflicts of interests, many of the disputes between SEC / FSA and investment banks involve individual interests. These experiences form the basis for arguments to separate the research department from the investment banks.
Within an investment bank, the personal trading compliance process follows four distinctive phases:
1. Restricted list watch: Restricted list of securities are predefined and broadly communicated to employees who matter from the perspective of privileged access. This list restricts employees trading in securities where the bank has built the holding and calls for mandatory disclosure. Depending on the holding percentage which may vary from country to country, it is the bank's responsibility to maintain and update the restricted list to avoid any conflict of interest. FSA in the UK, as per rule number 7.3, checks for possible conflict of interest which includes front running (staff deals ahead of investors in the securities based on privileged access). Similarly, SEC 17j-1, rule 204-A-1 calls for the employee to obtain a duplicate brokerage statement and submit it to their employer bank.
2. Pre trade clearance: Banks have a list of 'what not to buy'. However, pre trade clearances are obtained through e-mails or by signing paper documents and often, this is done post the trade. The delay in correspondence between the risk office and an employee often results in a breach of code of conduct. Eventually, these breaches find their way into audit reports and draw the attention of regulators.
3. Broker confirmation: Though many employees diligently submit their confirmation duplicate to the bank, it is generally filed with the individual employee's records. There is hardly any automated process to reconcile the various broker confirmation receipts that an employee files from time to time. Tracing back to the point of any breach of trust is not only time consuming but also manual which means there is scope for human error.
4. Documentation: This is one of the weakest links in the chain. Poor documentation of an employee's personal trading history affect the firm's ability to pin point where the blame lies. From a compliance perspective, gathering information from various sources to synthesize and then arrive at a meaningful conclusion is still challenging.
Emerging regulations across the globe clamor for a different approach. Considering the external stimulation and more awareness on the need for better conduct internally, investment banks are looking for solutions that will enable them to stay informed and track employee personal trading to the spirit of the laws rather than the letters. Essentially, this requires behavioral changes at an employee level. But automating the process of gathering and creating reports on personal trading compliance would reduce the number of questions raised by the auditor in the short-term, and help in brand building in the long-term.