How regulators catch trading errors

For markets to operate fairly and efficiently, all participants must monitor their trading activities. The requirements include having pre-trade controls, post-trade monitoring, and sending of data feeds to regulators and clearinghouses. This includes Canada’s CDS Clearing and Depository Services (CDS), which is part of a corporation owned jointly by the TMX Group, Canada’s major chartered banks, and members of IIROC.

According to CDS, market participants must also :

• be incorporated;
• comply with regulations; and
• meet minimum capital requirements and stability standards.

While these systems provide comfort, advisors still need to know how markets operate—including how trades are entered and tracked properly, say experts. This will help cut down on transaction delays, and reduce the possibility of mistakes and client complaints. Start by keeping up-to-date on your firm’s securities trading policies, and transactions and commission thresholds. This way, you’ll be able to alert compliance early if a mistake is made during order input. One of the main ways execution errors are identified is through exception reports, which are run when trades don’t go as expected. Here’s how they work.

Catching errors

For trades on exchanges to clear, the data sent by sellers, buyers and any third parties has to match before it’s sent to CDS. If it doesn’t, discrepancies must be resolved before the trades can settle. To do this, compliance teams must follow up on execution errors through exception reports, and investigate why trading data, such as listed quantities or prices, doesn’t match.

Read: IIROC proposes fee model for debt market regulation

If a clearinghouse can’t close a non-exchange trade that’s entered by a direct market participant (see “Matching flow for participants,” chart below), CDS notifies both parties involved in the trade. So, if an investment manager and broker send different price data to CDS for the same trade, a representative will contact them.

Exception reports are then sent to each party to request details on any trades in question. If several trades are being investigated, the report will show all the transactions CDS has processed for them over a specific time period.

For instance, there could be a price deviation, since each party uses different algorithms through their brokerages or back offices. As a result, one party might’ve set the trade price at $500, while the other said $501.

Read: Firms failing to grasp compliance basics: IIROC

When this happens, both parties have to review the information CDS sends them, and tell the agency whether the current trade can be approved as entered, or if corrections need to be made. For instance, if it’s an equity order, the discrepancy must be settled within three days after the trade was entered.

If trading problems are more complicated, a party may have to self-report to regulators, says a trading surveillance expert from Toronto. Under the Payment Clearing and Settlement Act, CDS and its participants are federally regulated by the Bank of Canada, and provincially through securities regulators. In Quebec, CDS is regulated by the AMF, and the corporation also reports to the CSA. Self-reporting may be required if a trade isn’t marked properly and then corrected later, for example. Even if the trade has already gone through, this ensures a party is proactively reporting any discrepancies that are found during audits. This is key, since regulators assess firms’ risk controls. And when they do, they review which exception reports are used and why.

Read: 5 items regulators focus on when you’re audited

If a firm enters fewer than a dozen trades a day, reporting may be manual and regulators can more easily spot problems. Meanwhile, firms that enter millions of orders each day typically use automated reporting to handle the large volumes of data.

Types of exception reports

There are hundreds of types of exception reports used by firms, clearinghouses and regulators. Here are examples, based on documents provided by a trade surveillance supervisor in Toronto.

• Front running reports These show when a house trade executes prior to a client trade. When an order to fill or cancel occurs within 30 minutes prior to a client trade, for example, these reports help investigate all activity related to the specific stock or instrument in question.
• High close executions reports These show when end-of-day executions are active trades at the bid or offer stage. These are sometimes done to push instruments to an artificial closing price by waiting to execute until the end of the day.
• Spoofing reports. These show when traders issue buy orders and then immediately cancel them in an attempt to move a stock’s market price or create the impression of demand when none actually exists.

Expanded list of exception reports

Further, if regulators do identify market problems, surveillance staff could schedule extra reviews to investigate any red flags. So whether problems are found through audits, self-reporting or client complaints, any advisors who are involved should be prepared to provide trading documentation. If a firm uses a third-party clearance and settlement operation, people there may also be questioned. Then, depending on regulators’ findings, the firm may receive a deficiency notice or other disciplinary action could be taken.

Read: When must firm auditors call regulators?

Trade execution basics

In most cases, buyers and sellers use third parties, such as brokers or advisors, to trade on their behalf—this can be for regular trading requests or discretionary accounts.

Orders put through on listed markets are tracked by their compliance departments electronically, and processed and monitored electronically by depositories and clearinghouses.

One of the “roles of organized marketplaces is to ensure transparent and centralized trading of listed securities, which allows for activities on all marketplaces to be reported to IIROC for real-time surveillance and regulation,” says Fionnuala Martin, an independent consultant in Toronto. “Execution in a multiple marketplace environment is complicated, given the number of parties involved. However, centralized trading offers a number of important benefits to the industry, including control, measurability, transparency, authenticity, standardization and regulation.”

In some cases, large-scale clients, such as pension plans, are validated by regulators and allowed to access markets directly; so they act on their own behalf, similar to brokers that are making trades internally. These parties could send an order to a broker, who will then send it to the marketplace, or they could send it directly via electronic access.

However, the trade still goes through broker systems that have risk controls in place. The pension plan is managing its order flow, and then settlements are distributed to all clients.