Automation of Trade Compliance - Emerging Challenges
If we truly want to understand the genesis of the compliance regime, one has to step back in time to the 1990s. Those were the days when a brokerage firm could execute a customer order as it wanted, pass on worse prices than the firm’s own purchases and make money by playing on market movements due to big client orders. The regulators at that time could not regulate these activities as they were more focused on macro level market infrastructure rather than micro level broker client interactions. Controlling some of these market practices was difficult as they were under a camouflage of inflexible trading infrastructure, improper order trails, hopeless execution quality and a lot of manual intervention, which came from the ‘open outcry’ or ‘hybrid’ system of trading.
The only major justification for a decent trade compliance system is control of reputation risk. Any investment bank will vouch for the fact that their premier position is attributed solely to goodwill perceived by corporates and individuals. They will also vouch for the fact that goodwill is fragile and takes a lot of effort and money to maintain. No wonder the investment banks pay their SEC fines in millions quickly without contesting them but with the clause ‘without accepting or denying’ the allegations from the regulator.
Erosion in the value of goodwill is difficult to estimate, but if it is eroded then the demise of the investment bank will also follow. The huge amount of fines paid out for non-compliance is by itself enough justification for setting up an automated compliance system. One just needs to browse through the SEC press releases published on its website to find out about the (not so publicized) amounts paid in fines.
Compliance as an area has been identified as a concern for many Wall Street firms and automation of this area is a key trend of 2005, as indicated by the industry analysts of TowerGroup and Celent. It is imperative to address the automation of this area as quickly as possible, but at the same time companies need to be aware of the emerging challenges that need to be tackled. An exhaustive list of these challenges is not feasible, but a discussion of some of the key ones below will help big brokerages to develop a planned approach to compliance automation.
Compliance by itself is composed of smaller areas such as anti-money laundering, equities, futures, traders and clients headed by extremely territorial managers. Getting the individual managers to agree on a common firm-wide compliance infrastructure is one of the biggest hurdles towards totally automated compliance. The main reason behind the lack of consensus is because of data sharing, as some of the individual areas may not be willing to share data and hide behind the veil of firm policy or legal obligation.
Moreover, unless the common compliance infrastructure idea comes from top management in the form of a ‘diktat’, the individual managers will guard their areas very closely. It has to be kept in mind that an integrated compliance system involves a lot of development effort and time, whether it is being developed in house or through the adoption of a product, therefore co-operation is of utmost importance throughout the life cycle of the implementation.
Trade compliance is a virtual impossibility without data (whether it be transaction or market data) and sourcing this data is critical. Data for trade surveillance will have to be extracted from databases, enriched, formatted and populated in a common data format for deriving the reports. Some of the issues that are commonly faced are:
Compliance is a relatively new area and regulatory oversight is yet to reach the desired level of maturity and stability. This is partly due to the fact that the regulators’ themselves are still in the process of experimentation and are not able to gauge precisely the impact of a regulation on market participants. A regulation is therefore followed by a series of amendments to fine-tune it. This is perfectly justifiable from the regulators perspective but to the compliance system it results in system ‘breaks’ unless the infrastructure is flexible enough to accommodate it. This flexibility will decide the ‘turnaround’ time to accommodate these changes.
On the same theme, a question at the back of the mind of a technical architect designing the system is: ‘how much flexibility?’ There can never be a straight forward answer to this. System flexibility and performance go hand in hand and so a trade-off has to be made, and expectations have to be set once the trade-off level is pinpointed.
To expect ‘one size fits all’ off-the-shelf products for compliance is unrealistic. But at the same time products that have been designed to handle frequent changes, or to incorporate new surveillance modules relatively easily, will have the advantage in the future. For some firms who are late starters or do not have development capabilities, the ‘off-the-shelf’ products give them time to market advantage. Some of the bigger firms who have a huge IT department also look for ‘off-the-shelf’ products not only for time to market considerations but also to justify to the regulator that they are taking active steps and are serious about compliance.
The chances of functional ‘off-the-shelf’ products becoming available in the market is extremely low and has to be customized extensively – because it has been a seller’s market there was a premium (i.e. high costs for products) on gaining first mover advantage. Recently that advantage is wearing off unless the vendor takes active steps to improve the product and cater to newer regulations like Reg SHO, Reg NMS and specialist surveillance guidelines. Some of the common issues with the current products are:
In a nutshell, there are no products that cater to global, multi-product brokerages and there is no way in which a product(s) can fulfill the trade surveillance requirements of the firm. Products can cater to some areas and can be cloned and modified for other areas though. The firm’s reliance, therefore, on ad-hoc surveillance will continue for some time to come.
In the past, firms could get away with shoddy compliance systems set up to appease the regulators rather than a serious attempt to regulate the traders. The firms who realize that their reputation is a big driver in the financial world, and who realize that some sort of ethical standard needs to be maintained, will be ahead of the game in the new compliance framework.
The benefit of a compliance system is not based on the savings of not doing it but a mandate for the very survival of the firm. This extract from the SEC Chairman’s speech explains it well: “There is often a temptation to cut back, or skimp, on compliance assurance, on the theory that compliance and legal staff do not increase the bottom line. That view, of course, is terribly mistaken. Compliance and legal staff contribute to the bottom line in the most important way possible – they assure that their firms retain and improve their reputation, thus allowing their firms not only to remain in business but to continue to thrive in this unpredictable milieu. Cutting back on compliance is a sure-fire prescription for disaster and the erosion of public confidence.”
It will be not be long before the regulator catches up with firms that are not facing their compliance obligations and fine them with amounts that are far more than the cost of the best compliance system. Should any firm be willing to take a chance on their reputation? I am sure the answer must be an emphatic ‘No’.
The thoughts expressed in this paper are the author’s own opinion and may or may not necessarily reflect the opinion of Infosys Technologies Ltd.