MAR at Work: Top 3 Considerations for Derivatives Surveillance Systems

By Stefan Hendrickx, Ancoa

Originally published on Tabb Forum

From July 3, 2016, the Market Abuse Regulation will require regulated firms to detect and report suspicious orders, as well as provide proof to regulators that effective systems aimed at preventing market abuse are in place. Technical challenges remain, however, in order to effectively monitor potential market abuse in the derivatives industry. Here are three main criteria for firms considering the buy vs. build options when it comes to implementing a surveillance solution.

The 9th Annual International Derivatives Expo (IDX) will take place in London June 7-8, notably just under four weeks away from the implementation of the Market Abuse Regulation (MAR). The IDX event, focused on the latest developments in the listed derivatives and cleared swaps industry, will be hosting a panel entitled “The Market Abuse Regulation: July 3 and Beyond,” which intends to address some of the main issues still confronting firms as they work toward ensuring compliance with the new rules.

From July 3, 2016, MAR will require various regulated firms to detect and report suspicious orders (in addition to suspicious transactions), as well as provide proof to regulators that effective systems aimed at preventing market abuse are in place. Firms trading derivatives need to be cautious when negotiating the bumpy road ahead.

Technical challenges ahead

MAR, the updated version of the Market Abuse Directive, will apply to a wider range of securities and derivatives, and will cover financial instruments admitted to trading on other trading platforms (i.e., MTFs and OTFs) and related financial instruments. The Futures Industry Association (FIA) has done some extensive work in anticipation of MAR in order to compile possible abuse scenarios in the derivatives markets. Technical challenges remain, however, in order to effectively monitor potential market abuse in the derivatives industry.

In particular, challenges are focused around the ability of surveillance systems in general to properly accommodate options and other derivatives, for example:

• Deciphering ambiguous symbology: In order to correctly analyze the data cross-market and cross-asset class, a solid approach in mapping a singular, unambiguous symbology for instruments is needed, covering all markets traded on. For example, markets may use ISIN, RIC, SEDOL, CUSIP, Bloomberg or other codes, though it is only through unified representations that a central view across venues will be achieved.
• Modelling and visualizing related instruments: Ideally, the ability to identify related instruments should be easily attained. This can be discovered through matching expiry dates, providing the ability to visualize volatility skews across these instruments, for example, to help identify any abnormal spreads.

Challenges also exist concerning the ability to efficiently analyze and store market data, including:

• A consolidated view: Many firms lack a consolidated historical market-wide view of the relevant data, thereby falling short in their ability to overlay their own data with broader market data. It is only with this contextual view of overlaying data that abnormal patterns can be effectively spotted. Whilst some firms do hold records of all activity, they may be held in distributed repositories. In other cases, a central view of trades may be in place, but records of orders or quotes are distributed across multiple data centres.
• Data volumes: A high-performance database is required to handle and efficiently store the large data volumes that options traders have to deal with.

The key is that from July 3, regardless of their respective size, firms will have to prove to regulators that an appropriate surveillance system is in place. ESMA’s Q&A document on MAR (May 30, 2016) made clear this does include buy-side firms, including investment managers and proprietary trading firms.

It should be noted that in the Regulatory Technical Standards, the European Securities and Markets Authority (ESMA) has deemed that for the large majority of cases, an automated surveillance system is the only method capable of analyzing every transaction and order, individually and comparatively. Firms are therefore faced with a choice when it comes to implementing automated surveillance tools – namely, to buy a ready-made vendor solution or build one from scratch. We have identified three main criteria for firms considering the buy vs. build options:

• Timing: Given the short deadline until the implementation of MAR, time to market of a surveillance product has become critical. In terms of deployment, a vendor solution may take a few weeks to deploy, rather than the years it may take for a firm to build its own.
• Capability: Because market abuse will be considered a criminal offence under MAR, the onus will be on firms to establish a successful methodology when implementing a surveillance system rather than an unknown result. Proven technologies provide greater assurance.
• Running costs: Ongoing maintenance costs are an inevitability with home-build systems as regulations and market abuse scenarios change over time. A vendor solution can utilise best practice across the industry rather than a singular firm running an insular approach.

Those firms that already have completed this decision-making process are reporting that regulators are much more at ease with their choice to “buy” because the regulators are more familiar with the processes and expertise coming from large vendor solutions, giving them a far greater level of confidence.

You are now entering a MAR area

In less than a month, firms will need to make substantial changes to compliance procedures in order to implement the new rules applying to MAR. The U.K.'s FCA recently put out a notice recognizing the tight timeframe, though they articulated that there would still be an expectation of firms “to demonstrate that they have made best efforts to achieve full compliance, and be ready to explain how approaches will be further developed” as well as for “detailed and realistic plans to be in place, which we may request to see at any time.”

With the forward-looking sessions of the FIA around MAR, market participants and surveillance vendors have been in a position for a while now to prepare themselves for the technical challenges that derivatives and options traders will face. This includes the organization of the data itself, as well as the specification of the necessary derivative-focused alert scenarios and visualizations across instruments and markets. MAR compliance may well indeed still be under construction, though authorized personnel – in the form of market surveillance vendors – can help safely negotiate derivatives firms through this complex “danger” zone.