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Bates Research  |  04-27-23

Special Report - FINRA and SEC Increase Scrutiny of Market Manipulation: Old Concerns, New Priorities

Image © [leungchopan] /Adobe Stock

In FINRA’s 2023 Examinations and Risk Monitoring Report, the regulator highlighted a new category of regulatory obligations and related considerations over manipulative trading (see previous Bates coverage). Manipulative practices in various forms—pump and dump schemes, insider trading, wash sales, layering, front running, trading ahead, spoofing—have been longstanding violations of numerous SEC and FINRA prohibitions. The regulators are now paying extra attention to issues of market manipulation due in part to an increase in wash sales and front running (as pointed out by Greg Ruppert, Executive Vice President, Member Supervision, FINRA, at a recent SIFMA C&L Society luncheon in NYC), as well as to the regulators' use of more sophisticated data analytics to identify potential market abuse. In this article, we look at recent enforcement actions, examination findings, and guidance for firms on the issue.

Enforcement

In 2022, the SEC engaged in high-profile enforcement actions to address abusive market practices. These included prosecutions based on data analytics from the SEC’s Market Abuse Unit (MAU), a group created in 2010 to uncover and detect patterns of suspicious activity. Highlights from last year included (i) insider trading cases against a Chief Financial Officer of a pharmaceutical company (along with his former romantic partner) and a CEO and Chief Technology Officer of a mobile internet company; (ii) manipulative schemes concerning microcap stocks against multiple individuals and entities; (iii) “cherry-picking” trading abuse cases against investment advisers and associated representatives; and (iv) an insider trading and front running scheme wherein a trader at a major asset management firm advised an outside party on market moving trades prior to their execution, leading to $47 million in profits over a six-year period

This year, SEC enforcement cases charging market manipulation are picking up. The most watched cases concern crypto companies and their executives. They include a CFTC action against the Binance Exchange, which concerns, among other things, claims that the exchange participated in market manipulation and used its position to trade against its users. Another recent case includes charges by the SEC against crypto asset executives and their companies for “fraudulently manipulating the secondary market … through extensive wash trading.” (This case also concerns a scheme to pay celebrities to tout the crypto assets without disclosing their compensation.)

FINRA’s most recent enforcement actions are anchored in a host of relevant rules (see below), but often take the form of supervisory failings. One recent settlement imposed fines for not establishing and maintaining a supervisory system, including written procedures, regarding surveilling for potentially manipulative trading (in a case in which the firm had been alerted to a customer’s prior history involving trading and margin calls). Another case concerned a failure to conduct supervisory reviews on “electronic trading customers’ trading activity for any type of potentially manipulative trading, including layering, spoofing, wash sales, or marking the close or open,” relying instead on “third-party broker-dealers to conduct such reviews.” Yet another case concerned a supervisory system “not reasonably designed with respect to detecting potentially manipulative trading involving wash trades, prearranged trading, and marking-the-close.” These actions further the intent of the regulators to prioritize manipulative trading enforcement.

Requirements

Rules to prevent or deter market manipulation are extensive. The SEC prohibitions generally fall into two categories, (i) “pump and dump” schemes and (ii) trading manipulations. The former largely concerns insiders or promoters who obtain ownership or control of a significant block of a stock, then hype the stock, often using press releases, web sites, chat groups, and email. This generates artificial interest from the public, causing prices to rise until the manipulators “dump,” or sell, their own shares to the unsuspecting public and walk away with the profits, leaving investors holding largely worthless stock. 

Trading manipulations take numerous forms, including, for example: arbitrary quotes (where trading patterns do not follow expected patterns of supply and demand); wash sales and matched orders (where the trading does not change beneficial ownership, or expose the trader to market risk, but creates the impression of activity to move prices for a security higher); marking the close (a trading scheme to up a bid or to increase the closing price of the security, to signal to investors a trend in the market or to increase the value of held positions); “domination and control” (a market maker scheme leveraging control of trading in a particular security such that quotes can be set arbitrarily after luring in momentum traders); and layering (where a trader places non-bona fide orders at different price levels in the order book for the purpose of creating a false picture of market supply and demand for other traders).

FINRA rules covering potential market manipulation may implicate requirements against publishing communications about transactions and quotations unless they are “bona fide” (Rule 5210), offers at stated prices (Rule 5220), payments involving publications that can influence market prices (Rule 5230), anti-intimidation or coordination (Rule 5240), “front running” rules that prohibit trading in a security that is the subject of an imminent customer block transaction if you possess related material, non-public market information (Rule 5270), order entry (Rule 5290), and, generally, “other trading practices" Rule 6140). These requirements are all subject to supervisory responsibilities of a firm (Rule 3110) to ensure that associated persons’ trading activities conform. Violations of these rules tend to also implicate FINRA’s catch-all Rule 2010 (Standards of Commercial Honor and Principles of Trade) and/or, generally, Rule 2020 (Use of Manipulative, Deceptive or Other Fraudulent Devices).

Examinations

In their summary of exam findings, FINRA identified compliance deficiencies regarding (i) written supervisory procedures (particularly as to monitoring and escalating potentially manipulative conduct); (ii) failures to design and establish appropriate surveillance controls and thresholds; and (iii) surveillance failures, including inadequate monitoring, review and documentation, and training.  

Given the extent of the compliance problem, FINRA recommended steps firms should take to address the above issues. These include boosting monitoring across multiple platforms and products and strengthening supervisory processes. As to surveillance, FINRA zoomed in on specific priorities. The first was to improve monitoring on algorithmic and high frequency trading. FINRA recommended firms focus on surveillance to improve general risk assessment and response; software/code development and implementation; software testing and system validation; and trading systems (see FINRA guidance).

Second, FINRA recommended strengthening surveillance to catch potential momentum ignition trading, including variations of layering/spoofing and marking the close.

Third, FINRA wants firms to enhance their monitoring to detect customers engaging in wash trading (a manipulation strategy whereby a trader buys and sells in a manner that creates the misleading impression of market activity to other investors). FINRA expects firms to monitor accounts—identified in surveillance reports or based on information in account opening documents—that receive liquidity rebates from exchanges.

As for recommendations to improve supervision, FINRA prioritized oversight on exchange-traded products. FINRA recommended ensuring compliance steps to (i) protect material, non-public information from being misused; (ii) review for strategies that may exploit exchange-traded product processes like formation or redemption; and (iii) ensure that the program is tailored to how the firm actually trades these products.

Conclusion

As a policy matter, it is clear that regulators have found trading manipulation rules useful as an enforcement tool in the ongoing market turmoil and regulatory uncertainty of the crypto industry. 2023 should prove to be a pivotal year in how this will evolve.

As a regulatory compliance matter, the elevation of market manipulation as a priority for the SEC and FINRA demands attention to firms’ policies and programs. In this, there is a familiar pattern of regulators setting new expectations, offering guidance and warnings, underscoring their intent in the examination process and ultimately in enforcement action. With more and more sophisticated analytics in use, trading abuse cases are easier to detect and to prosecute. That advantage, of course, is not one-sided.

Alex Russell, Bates Managing Director and Regulatory practice leader cautions that “It is extremely important for firms to understand what regulators may be looking to identify within the data. Understanding that helps firms determine the best way forward in anticipating and resolving any issue.”

How Bates Helps:

Bates has substantial experience with matters involving a variety of alleged market manipulation schemes, including: 

  • Wash trading 
  • Match trading  
  • Front running 
  • Painting the tape  
  • Banging the close  
  • Pump & dump schemes involving thinly traded securities 
  • High-frequency trading, such as spoofing and layering, as well as in the context of foreign exchange markets 
  • Insider trading

Bates frequently assists clients in internal investigations as well as in investigating allegations brought by U.S. authorities (SEC, CFTC, DOJ), self-regulatory organizations (including FINRA and exchanges), international agencies, and private parties. Our experts and staff bring high-level expertise when conducting detailed evaluations of the trading at issue, comparing the activity identified to (i) the pattern of trading for the security as a whole and (ii) the historical trading of the alleged manipulator(s).

Case Study:

In a representative matter, Bates used NASDAQ and TSX data to reconstruct the order book for a dually-registered security in order to evaluate the trading behavior and to determine the market impact caused by the behavior. Working with Counsel, Bates was able to create graphical representations of market activity that took place in microseconds, allowing the information to be presented to regulators in a digestible format. Bates analysis was used by Counsel to identify manipulative trading, and to highlight certain traders, based on short bursts of sell-initiated volume, pre-market selling with a position reversal at market open, volume of cancellations, order distance to best bid/offer of the cancelled order, and other indicators. Changes in market microstructure were evaluated on the basis of cancellation activity and trade-to-order volume, and (using SEC data) trading was contextualized against exchange norms and trading in peer companies. This allowed Counsel to narratively explain the activity in a way that clarified the intent (or lack of intent) of various actors, resulting in a change of direction in the focus of the investigation away from the client and towards other parties and entities.

We also work with firms to conduct testing and validation of alert systems to ensure supervision and control systems are working as intended.  

Learn more about how Bates Group can help your firm address manipulative trading investigations and controls.

Contact:

Special Report - FINRA and SEC Increase Scrutiny of Market Manipulation: Old Concerns, New Priorities

Alex Russell

Managing Director, White Collar, Regulatory and Internal Investigations

arussell@batesgroup.com

971-250-4353

Contact Bates Group

Bates Group is with you every step of the way. Contact us today for more information on how our End-to-End Solutions can help your firm.