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SAC Capital Case Turns Up the Heat on Monitoring for Insider Trading

Hedge funds are beginning to analyze the behavior of traders through analytics, and open-source tools for extracting information from text and voice conversations are accessible and affordable.

Last week brought riveting headlines about SAC Capital Advisers pleading guilty to five charges of fraud and agreeing to pay a penalty of about $1.2 billion to federal prosecutors as it tries to settle insider trading matter that has dogged the firm for a decade.

In numerous articles about the allegations, SAC Capital’s spokesman stated that the firm takes compliance very seriously and never encouraged insider trading. In a Reuters article, Solomon Weissberg, a partner at Barnes & Thornburg in Washington, D.C., and author of "White Collar Crime: Securities Fraud," commented: "The story is basically that there's a whole culture here where red flags were ignored, (and) compliance efforts were more or less window dressing.”

The case is a cautionary tale for the rest of the hedge fund industry. It raises questions about what role the culture plays in fostering a competitive environment to find new investment ideas, and how firms can use technology to detect traders and analysts who violate securities regulations.

“Firms are looking at this high profile case and deciding what to do, how far to go in their technology spending,” comments Alexei Miller, EVP at DataArt, a custom software development firm that focuses on compliance and surveillance technologies for buy side firms.

“You can never prevent a rogue employee in an organization from doing something bad or illegal. But you can spend a lot of money and have 65% or 68% protection,” says Miller. Even if firms spend more money on compliance, they may not get 100% coverage. “There’s a law of diminishing returns where you spend increasing amounts of money and you get X percent of protection,” says Miller. We know that firms rely on archiving and filtering their emails as well as instant messages, but preserving this information may not be enough, according to Miller.

Tracking Irrational Behaviors

While the tools are still young, there’s an emerging field around analyzing behavioral patterns of individuals within organizations that can be applied to detection of insider trading. Daniel Kahneman, an Israeli-American psychologist and winner of the 2002 Nobel Memorial Prize in Economic Sciences, pioneered this field. He is notable for his work on the psychology of judgment and decision-making, behavioral economics and hedonic psychology, according to Wikipedia. Kahneman is the author of bestseller Thinking Fast and Slow where he describes the roots of irrational behavior, cognitive biases and various mental systems can be used to analyze behaviors. This was a school of psychology and sociology originated in the 1980s by behavioral scientists that didn’t have anything to do with finance, but now some people are applying it to Wall Street behavior, says Miller. While for a long time this was applied to fraud detection and to suspicious behavior, Miller knows of a few trading groups in London that are beginning to apply to analyzing trader behavior.

It’s looking at whether certain actions or trades can be explained by behaviors at the time. “It has wider implications, for example, if a certain trader is behaving irrationally on the trading floor, it’s of interest to the organization even if he is not engaged in behavior for anything illegal,” relates Miller.

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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