Wall-crossings and inside information: Good practice, poor practice from the FCA

What is good practice in handling inside information? How should “wall-crossings” best be done? The Financial Conduct Authority takes on these questions in a recent paper, “Asset management firms and the risk of market abuse”.

Although primarily aimed at asset management firms, what the paper has to say about the management of inside information and containing market abuse risk will be of particular interest to the sell side and to advisers.

The FCA’s thematic review on controlling the risk of market abuse: a focus on equities and insider dealing

The paper presents the FCA’s findings from its thematic review of how asset management firms control the risk of committing market abuse. That review “considered how firms control the risks of insider dealing, improper disclosure and market manipulation, with a primary focus on equities and insider dealing”. Out of that review, the FCA communicates some key messages:

• practices and procedures to control the risk of market abuse are “comprehensive in a small number of firms”, but in many firms “further work is required”;
• in particular, firms need “to pay more attention to the possibility of receiving inside information through all aspects of the investment process and take steps to manage this risk”; and
• and firms generally need to improve the effectiveness of post-trade surveillance.

Good practice, poor practice: examples from the front line

The most useful part of the FCA paper is its description of good and bad practices it found at asset management firms during its thematic review. We pull some of these out below; but for those involved in this field, the whole paper is, at 13 relatively snappy pages, certainly worth a read.

Managing the risk that inside information could be received but not identified

Firms generally had effective policies to identify and capture inside information that was intentionally received through wall-crossings by investment banks, but not for when such information was unintentionally received.

Wall crossings, good practice: “Five firms had an initial point of contact for soundings that was independent of the fund managers. In some cases this enabled soundings to be rejected without sharing any information with fund manager…”.

Wall crossings, poor practice: “In one firm we found that a fund manager had been told the name of the company that was planning a corporate action during a sounding but took no further information. The fund manager recognised this was potentially inside information and decided not to trade any of the company’s shares. However, the company was not added to the restricted list and the compliance function was unaware of this situation. This created the risk of another fund manager trading while inside information was held in the firm.”

Company-specific research, good practice:

• “Fund managers at one firm reduced the risk of receiving inside information from investee companies by avoiding any meetings with them during close periods…other than in exceptional circumstances and following pre-clearance from compliance.”

• “One firm prevented fund managers from meeting with consultants who had recently worked for a listed company because of the possibility they could be in possession of inside information.”

• “In a smaller firm, the most senior fund manager regularly asked more junior staff about the content of meetings and whether there was any concern that inside information could have been received.”

Company-specific research, poor practice:

• “At one firm that did not have a consistent approach to meeting companies during close periods, fund managers had met with the management of a large listed company less than a week before it published results.”

• “In one firm, the compliance function was unaware that an investment team was using an alpha capture system (this enabled sell-side firms to submit trading ideas electronically through a dummy portfolio and to be allocated commission based on the returns of the dummy portfolio). The potential market abuse risks had not been appropriately considered…”
• “At two firms, fund managers viewed it as the responsibility of the management of listed companies, investment banks and other research providers to assess whether any information provided could be inside information.”

Controlling access to inside information and managing the risk of improper disclosure

All but one firm reviewed by the FCA used a restricted list to document the receipt of inside information, and practice was generally good in this area.

Access to inside information, good practice: “One firm we visited kept a detailed log of who knew inside information. Knowledge of the information was not shared beyond the person wall-crossed, other team members who needed the information to fulfil professional responsibilities (e.g. a fund manager who might participate in a proposed placing), and compliance.”

Access to inside information, poor practice: “One firm notified all traders when inside information had been received as an interim control to prevent trading until a system block was in place. In addition to being notified of the company name, the traders also received the detail of the inside information.”

Pre-trade controls to prevent market manipulation and insider dealing

All bar three firms had segregated dealing functions; in most of these, dealers had a reporting line which was independent of the fund managers.

All except two firms used system-based pre-trade controls to prevent trading in companies that had been restricted due to the possession of inside information. The majority of firms recorded staff fixed lines; a minority also recorded mobile phones.

Pre-trade controls, good practice:

• “In one firm, management considered the volume of trades to be too small to merit a segregated equity dealing function, but required all fund managers’ orders to be signed off by an independent colleague. This provided an opportunity to review any concerns prior to execution.”
• “In some firms, the trading function was situated in a segregated, secure area. Where a fund manager has placed a large trade relative to the volume of the security being traded, knowledge of this trade could be inside information for other fund managers; a physically segregated dealing function reduces the risk of other fund managers coming into contact with this information.”

Pre-trade controls, bad practice:

• “One firm with a large number of employees had no independent check prior to an order being placed. In another firm there was a segregated, independent, equity dealing function for all except one of the fund management teams. The exception was established because the fund manager thought trading would be improved by having a dealer within his team. No other compensating controls were put in place and this reduced the effectiveness of market abuse controls.”
• “One firm did not implement system-based trade restrictions on a timely basis following the receipt of inside information: this took several hours in some cases.”

Post-trade surveillance

The FCA says that only two firms in its review had a post-trade surveillance programme that was effective in identifying market abuse. The regulator observes that post-trade surveillance has a key role to play in both detecting and deterring market abuse, and that it expects senior management to operate and maintain processes to ensure that controls are working effectively.

Post-trade, good practice: “One firm we visited used statistical analysis to identify post-trade price movements outside a set probability range to trigger surveillance follow up. This price move trigger was varied by market according to that market’s volatility.”

Post-trade, poor practice: “One firm had no documentation of the research process and could not verify the trade rationale or what information had been used to inform the trading. This made it difficult to independently assess any trades highlighted by post-trade surveillance.”

Personal account dealing policies

All firms has a personal account (PA) dealing policy, as the FCA’s rules require.

PA, good practice: “All except for one firm required pre-trade approval for PA dealing and, in the majority of firms, there was a post-trade review to monitor for any suspicious activity.”

PA, poor practice: “Three firms did not effectively manage the risk of a fund manager trading ahead of a fund. Two of these firms had no requirement about what time would be required between a PA trade and a fund trade. Another firm only required that fund managers did not PA trade within one hour of a fund trade.”

The FCA paper also discusses the importance of firm training, with the aim of ensuring that “staff knowledge is sufficiently current for the firm to effectively identify, manage and monitor the risk of market abuse”.

Source: FCA, “Asset management firms and the risk of market abuse”