Insider Trading and Technology

Posted by Tara Phelan on Mar 28, 2017 8:07:36 PM

By IMDDA Staff - London

More often than not, industry-wide challenges solicit a reactive – as opposed to a proactive – response from hedge funds. Nowhere is this more evident than in how the industry deals with insider trading risks.

Expert networks - consultancies which provide specialized opinions about companies or industry sectors - are a brilliant example. Until a series of high-profile insider trading cases involving expert networks was pursued by the Securities and Exchange Commission (SEC) precipitating in a number of prosecutions, very little caution was exercised by hedge funds in their dealings with these consultancies. This was despite many of these “experts” being company insiders or privy to sensitive information, which could be used by managers and was in fact used by an unscrupulous few to make ill-gotten gains.

Conversations with expert networks are now only conducted in strictly monitored environments with meetings recorded and often with a compliance officer or general counsel in attendance. Most compliance and legal counsel strongly advise hedge funds against using expert networks or at least insist they implement an extremely controlled process when doing so. But what is the current challenge for hedge funds in the fight against insider trading?

Monitoring insider trading is not straightforward and the proliferation of new technology has made it even harder. The vast majority of individuals engaging in nefarious trading activities are unlikely to communicate their actions on a company email system or via a Bloomberg chat room following various LIBOR and rate-rigging prosecutions. All of these channels will typically be monitored with communications stored on a server for several years.

Most banks and fund managers deploy automated software to detect key or suspicious words. A list of flagged words on the Goldman Sachs email system include the obvious profanities but also mundane comments such as “remedy the situation”, “this time I promise” and “let me remind you.” That being said, some people are sufficiently unintelligent and will commit crimes through easily traceable mediums.

New technology such as messaging apps and social media do present a problem for firms when keeping an eye out for insider trading. Regulators, however, have been alert to the emergent threats of new technology for a long time. FINRA warned investment advisers back in 1999 that communicating with investors through a web chat room (remember those?) was no different to pitching in person to those clients.

Most firms prohibit the use of social media correspondence such as Facebook and even LinkedIn on workplace computers and cell phones, but such rules cannot be extended to personal laptops or smartphones. However, a growing number of firms do make it a sackable offense for employees to communicate investment advice or even their market views via social media even in a personal capacity.

The big difference though between web chat rooms of the late 1990s/early 2000s and contemporary apps was that communications conducted on the former were often auditable. Many of today’s applications are encrypted, making conversations difficult to track. Some apps auto-destruct conversations such as Confide and Snapchat. A tech-savvy insider trader could even create his/her own messaging app, something which has already been finessed by Islamic State. Such an app would be independent of any third party that might help law enforcement or regulators if pressured to do so.

In theory, a firm could impose a contractual ban on employees using auto-deleting messaging apps in any capacity (i.e. work and personal) but it would be impossible to monitor. The brutal reality is that accessible technology and sophisticated, encrypted applications make it nearly impossible for firms to continuously monitor their staff for insider trading.

At the minimum, firms need to implement best practices as laid out by regulators on guarding against insider trading. Demonstrating to regulators that systems and processes are robust is key. This could be by having a solid risk management oversight which is well versed in spotting suspicious trading activity, or even deploying predictive analysis software. Recording all correspondence such as phone calls and emails is an absolute must.

It is important for compliance teams to regularly educate staff about insider trading, but also engage with regulators routinely. Firms need to ensure they have protocols so that any questionable behavior is investigated thoroughly and if necessary reported to the authorities. Many organizations will have a process in place to allow whistle-blowers to escalate a problem or voice concerns to the appropriate member of staff. Evidence of such processes will be imperative in any defense.

While technology is making it harder for organization to detect spurious activity, it is abetting regulators and organizations in other ways. Algorithms and automated software enable the authorities and companies to identify suspicious trading activities. Technology is certainly allowing individuals to become more ingenious about conspiring to commit insider trading, but it is also helping regulators and firms better spot it.

Tags: Alternative Investments, Fund of Funds, Risk Management, Strategy and Asset Suitability, Article, Fraud Risk and Irregularities, Fund Structure, Hedge Funds, Insider Trading, investment, Regulatory and Compliance

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