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Ivy Schmerken
Ivy Schmerken
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Insider Trading Can Fly Under the Radar

Hedge funds need to install monitoring systems to plug gaps in internal controls, says technology executive.

As prosecutors and regulators take more of an aggressive stance on insider trading, these actions are turning up the pressure on hedge funds to reassess their internal controls.

Rather than wait for regulators to find allegations of insider trading, asset managers and hedge funds are better off proactively installing technology that can detect suspicious activity. That’s the message I took away from a recent conversation with Jim Heinzman, managing director of securities solutions at Nice Actimize, who is a former managing director at Bear Stearns where he held responsibilities for surveillance in the firm’s prime brokerage and equities businesses.

Heinzman contends that the insider trading convictions of hedge fund billionaire Raj Rajaratnam in the Galleon case, guilty pleas by consultants working for expert research networks, and the investigation of SAC Capital, among other cases, should serve as a wake up call for financial institutions that may not have internal controls to detect suspicious trading.

“Because of the Galleon case and the headlines and all the attention and media cycle, it’s really a big issue out there,” says Heinzman, managing director of securities solutions at Nice Actimize, a provider of technology for financial crime, risk and compliance.

Insider trading has been an issue for the sell side since the Ivan Boesky insider trading case surfaced in 1986, so historically sell side firms have had 25 years to develop more mature processes, according to Heinzman, who maintains that investment advisors have compliance apparatuses but are not as rigorous as the investment banks. “Most of the investment banks are using high-tech solutions like ours to look for market manipulation and generally have more controls, processes and procedures around that activity,” says Heinzman.

As of now, there are 12,000 hedge funds in the industry, but a significant number are lightly regulated or unregulated. “You had hedge funds that were not required to be registered and were lightly regulated,” he said.

Of course, that is about to change.

Under the Dodd-Frank financial reform legislation, hedge funds with $150 million or more in assets are required to register with the Securities and Exchange Commission by March 30, 2012 (delayed from July 21, 2011), while those that do not qualify for federal regulation will fall under state authorities.

Heinzman acknowledges that big hedge funds have already registered under the Investment Act of 1940, but the amount of investment the industry has made in compliance is actually small when compared to what they’ve spent on trading technology. “A lot of the hedge funds have robust technology infrastructures, but the investment is more in trading algorithms and quantitative analysis, and not so much in the compliance and trade monitoring. It just hasn’t been as big an emphasis until recently.”

In light of the high-profile insider trading cases, Heinzman says his firm is hearing from hedge funds as well as investment advisors that are starting to mature their compliance processes and are looking to plug the gaps. “So definitely these cases are triggering firms to look at their processes and it’s raising the bar.”

On the other hand, SAC Capital, a large sophisticated hedge fund manager that reportedly has a compliance department and has policies and procedures in place to detect insider trading, has fallen in the cross hairs of regulators. Several insider-trading cases involve former-portfolios managers who previously worked at SAC Capital.

“The regulators want to show they’re tough, that they’re protecting the integrity of the markets, and that they’re doing their job,” says Heinzman. “Plus, they have pressure from the media and Congress. That dynamic is a perfect storm,” says Heinzman. But he suggests that some of the zealous investigations appear to be politically motivated.

“As far as SAC Capital goes, the insider trading issue has become a political issue,” said Heinzman. The congressional committees (headed by Iowa Republican Senator Charles Grassley) have grilled Mary Schapiro about how her agency investigated the hedge fund run by billionaire trader Steve Cohen. “

But there’s also the issue of funds relying on spreadsheets and paper-based processes to track their trading activities, which is not a reasonable practice with today’s high volumes and complex strategies, warns Heinzman.

“When you have huge operations, like SAC with lots of activity and portfolios, it’s a lot to manage. It’s challenging for these funds, if they have a bad actor to try and identify it,” says Heinzman.

Heinzman says it’s important to have high-tech systems that take in data from different locations and pull it all together. It’s not enough to look at news events and who traded before a news event. “What happens if a news event happens and the market doesn’t react?” he asks, implying that insider trading can fly under the radar screen.

It’s not enough to look at equities since insider trading can involve derivatives and other asset classes. Options are “equities on steroids,” and offer more leverage so if someone was going to “bet the farm,” that would be the first place to look, he suggests.

A system like Nice Actimize looks at the price of a security and then it looks back in time to see who traded in front of that, and it looks forward in time to see when they unwound their positions. “If there’s an event such as earnings, and a firm trades before the announcement and then the price spikes and at the peak they sell out, with an automated system you have the ability to identify all the spikes and peaks,” says Heinzman, noting “That’s very similar to the technology that regulators use.

In fact, a Russian regulator purchased the company’s market surveillance solution in 2010, rapidly deploying it within 90 days. In the first week, the Federal Financial Markets Service, regulator of the Russian Federation’s financial markets, caught three cases of illicit trading activity, says Heinzman. “As soon as they turned the system on they started finding cases right away,” he says.


Ivy is Editor-at-Large for Advanced Trading and Wall Street & Technology. Ivy is responsible for writing in-depth feature articles, daily blogs and news articles with a focus on automated trading in the capital markets. As an industry expert, Ivy has reported on a myriad ... View Full Bio
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