BY CAROL E. CURTIS
The Securities and Exchange Commission, in a May 9 announcement that Morgan Stanley had agreed to pay out
nearly $8 million for failing to provide best execution on retail over-the-counter securities trades from 2001 to
2004, faulted the firm’s automated market-making system for allowing undisclosed markups and markdowns to be
embedded in some OTC orders. “By recklessly programming its order execution system to receive amounts that
should have gone to retail customers, Morgan Stanley violated its duty of best execution and defrauded its cus-
tomers,” Linda Thomsen, director of the SEC’s division of enforcement, said in a statement.
Morgan Stanley, which neither admitted nor denied guilt, agreed to retain an independent compliance consultant to review its automated order handling practices. (The SEC order was excerpted in the May 21 Securities Industry News.)
“The duty of best execution is not a static concept,” said Elaine Greenberg, associate regional director of the SEC’s Philadelphia office, “but rather one that evolves with changes in technology.” She might have been talking not just about best execution, but also risk management as it applies to technology-driven areas like electronic trading.
While electronic trading has fostered price competition, faster executions and lower transaction costs, it has also brought challenges in managing and mitigating risk. “In an automated trading environment, what you worry about is the sheer speed” of trades, says Jack Moorman, a principal in PricewaterhouseCoopers’ (PwC) technology forensics and analysis practice in Chicago. He notes that even with effective control systems to prevent unauthorized trades, “you can never catch everything.”
Information and system security present the greatest risk challenge, according to Moorman. He emphasizes that, in instances like the Morgan Stanley case, trading abuses can be prevented with effective employee screening, education and compliance. “To avoid inside abuses, you need to carefully screen your employees, provide training about security awareness, and regularly reaffirm that employees are in compliance [with laws and reg-ulations],” he says.
Although the Morgan case involved firm employees, Moorman warns that problems can just as likely come from outside. “Hackers can find a doorway,” he says. “There are groups that share malware. They may, for example, post a software program that enables programs to be loaded that look innocuous.”
To avoid potential security breaches, Moorman says firms must set up good control measures over the gates to their networks. “Controls around transactions ... include access, authentication, certification measures that have to be changed periodically, and [preventing] improper listening,” he says.
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When trading is automated, “the pace and flow of market data is quicker,” notes Cubillas Ding, senior analyst in the securities and investments group at Boston-based research firm Celent and author of “Risk and Pricing Analytics: Addressing Valuation Challenges in OTC and Structured Products,” a report published this month. “Automatic algorithmic trading strategies result in deci-sionmaking becoming more complicated because there is more information to be assimilated,” Ding says. “Traders need to make decisions in a more compressed timeframe.” That, arguably, increases the potential for error.
Ding says that business units must demonstrate transparency, and “it needs to be done systematically.” Although Ding’s report
focuses on valuation risks in complex and customized products that tend not to be electronically traded, he says that valuation remains an issue where automation is prevalent.
“A lot of trading systems have valuation modules in them,” the analyst notes. “Vendors like Murex, Wall Street Systems and Calypso Technology have valuation modules inside the trading package to price the instruments that are being traded.” Ding recommends that valuation processes be subject to a regular “ robustness health check” to identify vulnerabilities and ensure that appropriate controls and reviews are in place.
Risk reporting should be consolidated across business units, asset classes and geographies, says Ding, to get a true picture of where an organization’s exposures are. “The real issue is, how fast can you do that?” he adds. In the report, Ding cites Bank of Montreal’s $350 million trading loss in April, due to a downturn in natural gas prices, as an example of inadequate understanding of risk exposure. “What is interesting in this instance was that the trades and positions were all within the bank’s risk policies, yet the scope and magnitude of the impact of these contracts may not have been top of mind for senior managers in trading operations,” he writes. The bank lacked an accurate picture of its exposure due to inadequate risk reporting and internal communications, among other things.
At a PricewaterhouseCoopers-sponsored luncheon on the role of the financial expert in risk management on June 7 in New York, Dyan Decker, head of PwC’s forensic technology group, noted that because of the speed with which electronic trades are executed, “It is hard to block a trade.” As a result, she said, the focus needs to be on pre-trade rather than post-trade compliance.
“Pre-trade compliance is important because [with it] you have fewer downstream errors— you can catch” them up front, Ding notes. Many order management system vendors are active in pre-trade compliance, he says. When it comes to post-trade, he says vendors including SmartStream Technologies and CheckFree Corp. are supporting “trade breaks,” which involve monitoring and correcting errors to make sure a trade goes through to settlement.
One of the biggest risk factors, according to PwC’s Moorman, has a familiar ring: No matter what the trading environment, “you need to take reasonable measures to identify and rein in rogue behavior.” Moorman stresses the importance of security measures such as a hotline that employees can use to report unethical behavior, and that protects the whistleblower. “The one common theme is, what is the reputational risk for the corporation?” he says. “In all the cases I have worked on, the biggest concern for the organization is reputational risk. There may be a focus on IT security or malfunctioning software, but the thing that is most important to the company is reputation. So my advice is to trust, but verify.” ■
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