Chapter 7 Regulations PDF

CHAPTER 7 REGULATIONS  Chapter Objectives 1 Trading Rules and Rules Pertaining to Broker-Dealer Conduct Surveillance Enforcement Impact of Trading Rules and Surveillance on Corporate Outcomes ...

CHAPTER 7 REGULATIONS  Chapter Objectives 1 Trading Rules and Rules Pertaining to Broker-Dealer Conduct Surveillance Enforcement Impact of Trading Rules and Surveillance on Corporate Outcomes  Trading Rules 2 Securities regulation governs the permitted conduct of brokers and other market participants on stock exchanges. Most countries have a general rule that prohibits market misconduct in the form of manipulating share prices. However, market manipulation is not always perfectly clear, and, as such, different countries have adopted more specific rules at different points in time.  Trading Rules 3 The three main categories of trading rules are rules designed in order to: (i) Mitigate insider trading, (ii) Lessen market manipulation, and (iii) Control broker-agent conflicts Three main trading rules are Insider Trading Rules Market Manipulation Rules Broker-Agent Conflict Rules  Trading Rules 4 Insider Trading Rules Insider trading involves market participants who trade on material non- public information. The general public is likely more familiar with insider trading cases involving company directors or managers, although insider trading may involve any market participant, such as brokers. Client precedence Client precedence refers to brokers violating the time priority of client orders. A client precedence rule is violated during insider trading when a broker initiates a trade on his or her own account shortly before executing a client’s order, with the client’s trade being executed at a worse price. Violations of client precedence, by definition, violate price/time priority but do not by themselves give rise to a manipulated price or volume.  Trading Rules 5 Insider Trading Rules (cont’d) Front running Front running refers to brokers trading ahead of clients’ orders. In the case of front running, upon receipt of a large client order, a broker trades shortly before executing a client’s order with the expectation that the client’s order is likely to move the price. Front running is independently initiated by brokers and requires trade execution and a change in beneficial ownership. Other Forms of Insider Trading Other forms of insider trading can involve using material non-public information about the company being traded. Trading ahead of research reports is independently carried out by brokers and requires trade execution and a change in beneficial ownership. But trading ahead of research reports by itself does not give rise to a misleading price and volume.  Trading Rules 6 Market Manipulation Rules Market manipulation rules encompass price manipulation, volume manipulation, spoofing, and disclosure manipulation. Price Manipulation Rules Price manipulation can be carried out in many different ways and take various forms. One common way is when a client, broker, or colluding brokers enter purchase orders at successively higher prices to create the appearance of active interest in a security, which is also termed ramping/gouging. Clients may initiate intraday ramping/gouging, possibly independently or in collusion. Ramping/gouging requires trade execution. Another similar type of price manipulation is prearranged trading, which involves colluding parties simultaneously entering orders at an identical price and volume. Prearranged trades benefit all of the colluding brokers and may or may not give rise to misleading prices and volumes.  Trading Rules 7 Market Manipulation Rules (cont’d) Volume Manipulation Rules Volume manipulation can take two primary forms: churning and wash trading. Churning refers to the excessive trading of a stock to inflate its volume, thereby giving rise to the false impression that positive investor sentiment exists for the stock. Churning of both client positions and principal positions is initiated by the broker and requires trade execution. Churning inflates volume and may or may not give rise to misleading prices. Wash trading means having the same client reference on both sides of a trade. With the appearance of a higher volume, wash trading allows brokers to take their clients out of a position at a potentially higher price.  Trading Rules 8 Market Manipulation Rules (cont’d) Spoofing Manipulation Rules Spoofing, also known as painting the tape, is a form of market manipulation that involves actions taken by market participants to give an improper or false impression of unusual activity or price movement in a security. Entering fictitious orders involves entering orders on one side of the market, then completing orders on the other side of the market and deleting the original order after the trade occurs. Giving up priority refers to deleting orders on one side of the market as they approach priority and then entering the order again on the same side of the market. Giving up priority benefits the broker and/or client through misleading the order book and therefore misleading both price and volume. Having switches. Switches involve both sides of the market, unlike giving up priority, which is on one side of the market. Switches involve deleting orders on one side of the market as they approach priority and then entering the order again on the opposite side of the market.  Trading Rules 9 Market Manipulation Rules (cont’d) Spoofing Manipulation Rules (cont’d) Layering of bid/asks. Layering of bid/asks refers to traders or brokers who stagger orders from the same client reference at different price and volume levels to give the misleading impression of greater interest in the security from a more diverse set of exchange participants. Layering of bid/asks is initiated by a broker or client and can be done independently without colluding with others. Brokers/clients benefit by misleading price, but not volume. False Disclosure Rules False disclosure rules are distinct from insider trading rules and may or may not be specifically enumerated in securities laws and/or within an exchange’s rule book. For instance, market participants might actively distribute false or misleading information that has the effect of distorting the marketplace.  Trading Rules 10 Market Manipulation Rules (cont’d) False Disclosure Rules (cont’d) Parking or warehousing refers to the failure to disclose information, such as the mandatory disclosure of ownership interests above a certain threshold level, which is typically set at 5 percent in many countries around the world, by having third parties controlled by an individual or associates trading in their names. Clients benefit from parking/warehousing, but it does not directly affect price or volume.  Trading Rules 10 Broker-Agency Conflict Rules Brokers act on behalf of clients but can do so in ways that are against client interests (agency problem). Breach of a trade through obligation This type of principal-agent problem may arise from a broker’s failure to obtain the best price for a client Know-your-client rule A fundamental principle in the financial and trading industry that requires brokers or agents to thoroughly understand the financial profile, investment goals, risk tolerance, and other relevant details of their clients before recommending or executing trades. Key aspects Gathering Information: Collecting personal, financial, and investment details, including income, net worth, investment experience, and objectives. Assessing Suitability: Ensuring that recommendations or trades fit the client’s profile. Compliance and Risk Management: Meeting regulatory requirements and protecting both the client and broker from potential legal or financial risks.  Surveillance 11 Surveillance refers to automated computer algorithms that are used to detect manipulative trading patterns identified earlier. A necessary first step toward enforcement of securities laws is surveillance. Surveillance algorithms send messages called “alerts” to staff that work at securities commissions or the authority that governs the particular stock exchange. The alerts are in real time, meaning that market abuse is detected immediately. Cross-market surveillance refers to surveillance across different products, such as equity and a related option on the same underlying equity, and across markets or different exchanges or different countries. Cross-market surveillance is much more technical to perform and execute in terms of computing power.  Surveillance (cont’d) 12 The effectiveness of the surveillance systems in different jurisdictions around the world depends on various factors. Alerts should minimize false positives and maximize true positive manipulative practices. To be able to do this, the surveillance system needs to ascertain normal trading activity to set the abnormal alert parameters. For example, normal price and volume measures need to be set for typical trading ranges for a particular exchange- traded product. A surveillance department should be able to reconstruct all trading activity to replay the full order/quote schedule. Market surveillance should also identify the activity of each market participant. The surveillance staff should be versed on the issues that need to be investigated. A surveillance system’s quality depends on the quality of the software used and the degree to which the surveillance staff are educated and trained on using the information provided in the alerts.  Surveillance (cont’d) 13 The effectiveness of a surveillance system also depends on the degree to which market participants are informed about the surveillance activities. For cross-market surveillance, surveillance effectiveness depends to a large degree on the extent to which information is shared across jurisdictions. The efficiency of the surveillance system depends on the regulatory framework. In many jurisdictions around the world, the exchanges themselves are self-regulatory organizations (SROs) that establish their own listing standards and monitor and discipline market participants for violation of their rules of operation.  Enforcement 14 Countries with more capital market activity are more likely to detect market abuse. The legal quality in a country, with respect to the protection of shareholders and lenders, mitigates infringement activity. Enforcement authorities are more vigorous in detecting and reporting fraud when minimum pecuniary fines are higher. Legal enforcement of market abuse comes in three primary forms: (1) direct expenditures on enforcement officers, (2) quality of surveillance through information sharing and cooperation, and (3) rules pertaining to deterrence. Expenditures on enforcement officers, surveillance, and enforcement rules are effective mechanisms to fight fraud in financial markets and to increase investor confidence in the existence of sound capital markets.  Impact of Trading Rules 15 Impact of Trading Rules and Surveillance on Corporate Outcomes Market manipulation rules, surveillance, and enforcement can have implications that extend beyond market efficiency outcomes, such as liquidity. Market Manipulation and Mergers and Acquisitions (M&As) There is a possibility that stocks are manipulated before M&As to influence the likelihood of, and the terms of, an M&A transaction. End-of-day (EOD) prices, for example, can influence the price at which acquisition occurs. More detailed exchange-trading rules that govern manipulation across countries and over time lower the probability of withdrawal mitigate the negative impact of EOD manipulation on withdrawal and raise premiums paid. Market Manipulation and Innovation EOD manipulation gives rise to short-termism in managerial planning, which is inconsistent with long-term value maximization.  Impact of Trading Rules (cont’d) 16 Impact of Trading Rules and Surveillance on Corporate Outcomes (cont’d) Market Manipulation and Innovation (cont’d) EOD manipulation causes long-term harm to a firm’s equity values, and thereby reduces incentives for employees to innovate. Trading rules that curtail EOD manipulation, therefore, have an additional benefit of ensuring more innovative firms in the marketplace.  Summary 17 Different types of trading rules are designed to curtail a wide array of different types of market abuse. Without computerized surveillance and not merely single-market surveillance but more importantly cross-product and cross-market surveillance, trading rules are unenforceable and, therefore, meaningless. Securities regulation clearly improves measures of market efficiency, such as liquidity. Securities regulation likewise improves other corporate outcomes such as M&As and innovation.