Already battered by the financial crisis and the Madoff scandal, the hedge fund industry was further rocked as details emerged in late 2009 of the widest-reaching insider trading case in history. In early March, hedge fund chief executive Raj Rajaratnam finally went on trial, charged with 14 counts of conspiracy and securities fraud for allegedly trading on illegal stock tips he received from Silicon Valley sources.
The trial comes a year and a half after federal prosecutors, long criticized for their lack of action against white collar crime, signaled renewed intensity in their pursuit of insider trading by revealing that they had used wiretaps for the first time, to build the case against Rajaratnam, who founded the Galleon Group. Indeed, scrutiny of conversations -- conducted over the telephone or even via social media -- is playing an increasingly important role in regulators' hunt for abuses, according to Miranda Mizen, principal and head of European research at Tabb Group.
And it's not just in the United States. The U.K.'s Financial Services Authority recently extended the recording of cell phone conversations to hedge funds and expanded taping rules for brokers to include all voice and electronic communications, Mizen reports in a recent Tabb paper on market surveillance, "Dynamic Surveillance: Detection, Prevention and Deterrence."
The report stresses that regulators are watching closely the expanding use of social networks at capital markets firms, which until recently simply prohibited employees from using social networks because of compliance fears. Today, Bloomberg messaging, Twitter and Facebook all have been added to the list of products regulators are monitoring. "Financial firms are now firmly in an era when everything must be recorded, analyzed, archived and made retrievable," Mizen notes in her report.
Given regulators' new zeal, now more than ever it is in Wall Street firms' best interests to try to stop insider trading. If a firm catches the SEC's eye and regulators bring about insider trading charges against an employee, the consequences can be devastating for the firm. Galleon Group, for example, disintegrated when Rajaratnam was arrested.
"Firms recognize that insider trading and other serious compliance violations may significantly impact their business strategy or even pose a threat to their existence," says Yvonne Pytlik, chief compliance officer at Dreman Value Management, an asset management firm in Jersey City, N.J., for institutional clients that has $5 billion in assets under management.
Ramping Up Compliance Capabilities
To tackle the notoriously difficult challenge of stopping employees from illegally acting on inside information, financial organizations have been ramping up their compliance processes, policies and systems. "On the surface, when someone is requesting a trade, you need to look at whether there are any conflicts," says Carol Becket, compliance surveillance technology manager at Wolters Kluwer Financial Services. "What are the patterns on the trades? You need to compare that person's trade to the firm's trading.
"When you're looking at trading activity, you need automation," Becket continues. "It's not feasible to pull together information manually anymore. When you pre-clear trading, you need to look for restricted lists [of stocks that can't be traded due to access to inside information], as well as orders on the trading desk and short-term trading. You have to look for patterns, take things that may or may not have been flagged as a conflict and look at front-running reports. You need to pull data from one venue and then from another and put it together, compare it and make a report."
Pattern-detection technology has been around for some time -- but lately firms have become much more interested in adopting it, according to Jim Heinzman, managing director responsible for global securities markets products at NICE Actimize, which provides market surveillance and monitoring solutions to the capital markets industry. "We use a combination of profiles, pattern detection and analysis to look for cases that must be investigated," he reports. "Most of the stuff we've been doing for a while. But one of the differences is, the adoption rate is a lot higher now."
A few years ago, banks would just monitor blackout periods, simply prohibiting personal trades during this time, adds Dreman Value Management's Pytlik. "Now they are front-running reports, carrying out trend analysis, looking out for patterns," she says. "In the past they were using a simplistic approach. But now they are using much more sophisticated solutions to identify patterns and trends. I believe that more algorithm-based [surveillance] solutions will be evolving in the upcoming years."
A Better View of Threats
In addition to running more detailed analysis of trades to try to spot fraudulent patterns, Wall Street firms and vendors also have been increasingly focusing on providing enhanced, and more automated, reporting. For example, Advent Software-owned vendor Tamale recently added features to its research management solution that enable a chief compliance officer to "review and annotate notes" on companies and meetings that employees have entered in the system, says Mark Rice, SVP and general manager of Tamale. Recent enhancements to the solution also "include the ability to put an 'extract' on a CD, which can then be handed to the SEC on request," Rice notes.Melanie Rodier has worked as a print and broadcast journalist for over 10 years, covering business and finance, general news, and film trade news. Prior to joining Wall Street & Technology in April 2007, Melanie lived in Paris, where she worked for the International Herald ... View Full Bio