As trading markets grow more complex, the SEC increasingly relies on analytics to spot suspicious activity. Here’s what financial professionals need to know about the process.
It seems like the kind of crime that might be tough to catch: A financial professional cherry-picks stock trades for his clients. When he places trades on their behalf, he first runs the trades through a dummy account that he controls. If the trades lose money, he allocates them to the clients’ accounts. If the trades gain money, he allocates them to his own account. Heads, he wins. Tails, they lose. Over the course of about six years, the advisor generates more than $700,000 in illicit profits. He also gets caught when the SEC uses data analysis to identify suspicious trading patterns.1 The advisor goes to prison for two years and is banned from the securities industry for life.
In fact, that scenario shows how the agency’s approach to fighting fraudulent trades, insider trading, and other problems in the investment community is changing. In the past, the SEC took a more reactive stance. It waited until it received a notification about suspicious trading activity, often in advance of a merger announcement, and then investigated to see who traded in the security, and why. In other words, the investigation wouldn’t begin until after the trade happened, and it relied heavily on interviewing the people involved (who were more likely to have been able to coordinate their stories once they knew they were under investigation).2
In 2010, things changed. The SEC reorganized its enforcement division and created a Market Abuse Unit to get better at spotting suspicious activity. Within that unit is an Analysis and Detection Center (ADC), a kind of special-operations team of people with very specific expertise in trading, programming or white-collar criminal investigations. This in-house expertise allows the SEC to be far more proactive, identifying suspicious trading patterns as they’re happening. As a result, investigations can get far down the tracks before traders get tipped off.2
The ADC can run analytics that sift through traded data going back 15 years—and billions of rows of buy and sell orders—to spot patterns in which some people consistently trade ahead of good or bad news about a specific investment.3
That kind of analytical firepower is necessary because of the sheer size of the market. The SEC’s Office of Compliance Inspections and Examinations is responsible for overseeing more than 13,200 investment advisors—a number that grew nearly five percent in the past year alone—who collectively have about $84 trillion under management. Nearly 4,000 of those advisors have more than $1 billion within their own firms.4
And the enforcement tools are going to get better. Currently, the Market Abuse Unit does not have direct access to market trading data. Instead, it has “blue sheets,” or trade histories, that it pulled from various brokerage firms during investigations.3 (It’s like soldiers pulling hard drives out of a terrorist’s house and then using the information from those hard drives to prosecute additional people.)
But in the future, all trades—every order, execution, and cancellation—will be on a central database called a Consolidated Audit Trail. That database will pull information directly from stock exchanges and the Financial Industry Regulatory Authority (FINRA), giving regulators a more complete picture of the market at any given time. That system is currently in development and it should be in place by late 2019.
For financial advisors and their clients, this all should be reassuring. However, it puts an increasing burden on firms to make sure they have a strong plan in place to track and report all data regarding their clients’ trades.5 Compliance is more important than ever.
The SEC used to act like a security guard when it came to enforcement. Today, it acts like a surveillance system that’s monitoring markets 24/7. That smart, data-driven approach is good news for everyone.
1 “Press Release: SEC Uses Data Analysis to Detect Cherry-Picking by Broker,” SEC, Sept. 28, 2018.
2 Todd Ehret, “SEC’s Advanced Data Analytics Helps Detect Even the Smallest Illicit Market Activity,” Reuters, June 20, 2017.
3 “Here’s How the SEC is Using Big Data to Catch Insider Trading,” Fortune, Nov. 1, 2016.
4 2019 Examination Priorities, Office of Compliance Inspections and Examinations.
5 Mark Schoeff, Jr., “Regulators Use Big Data to Turn Up Enforcement Heat,” Investment News, Jan. 30, 2017.
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