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[The Detection Series] Layering may be the most formidable financial foe

As you’ve probably figured from some of our recent blogs, there are multiple forms of market abuse, and Layering is one of the most challenging forms to detect. On the surface, layering schemes seems implausible. Why would anyone place a sell order above the current offer price? Clever market abusers often issue simultaneous smaller sell orders at varying quantity and price. The end result is still the same: the illegal trading activity suggests that there will be more stocks for sale than there actually are, which manipulates their value.

Using AI to sniff out the bad actors

It’s not as easy as it sounds. Artificial intelligence (AI) is the future of market abuse monitoring but it has not yet been widely adopted. Sniffing out the bad actors isn’t something that automatically happens by introducing AI technology to fraud detection solutions. Developing the appropriate algorithms and rules is complex and is informed by data.

By monitoring electronic communications including chats, voice recordings, emails and so on, valuable trade-related information can be extracted and analyzed. The critical piece here is designing a correlation engine based on rule-based models and machine learning so that the system can, over time, improve its ability to contextually discover patterns of suspected market abuse. This includes detecting bulk sell orders issued in smaller quantities at varying prices for execution within a tightly limited time frame.

This is one of the patterns that advanced financial compliance solutions are designed to look for. They are built to flag the parallel or sequential (in rapid succession) placement of multiple orders. AI machine learning approaches drive algorithm and rule refinements by “learning” what those parallel or sequential sell orders look like in instances of confirmed market abuse.

In layering schemes, each sell order is placed just above or below the prevailing spread at different price levels to spur other traders to adjust their bids accordingly. The trade is conducted as soon as there is a better price option (reduced for a buy and increased for a sell). Here, the sequence of suspicious orders and executions is analyzed along with proximity to the prevailing spread. The timing of each transaction is closely monitored as one of the key indicators of layering.

Financial criminals do get caught but not very often

To date, one of the biggest cases of market fraud came to light in 2016. The traders were charged with market abuse for both spoofing and layering in December of that year. “Spoofing” references the illegal act of collecting information about a person’s identity and/or assets by pretending to be a legitimate institution or claiming to have a legitimized need to so do. In colloquial terms, this is often called a “scam.”  The SEC charged Joseph Taub and Elazar Shmalo of New Jersey, USA with market manipulation and presented evidence that the pair had masterminded both spoofing and layering schemes: both of which are illegal in most countries around the globe.

The two traders infiltrated NYSE and NASDAQ markets, successfully generating more than $26 million in profits through spoofing. Those profits were then layered across dozens of accounts at multiple brokerage firms. The pair reportedly executed tens of thousands of transactions that manipulated more than $10 billion worth of securities.

August 6, 2019, is a day of infamy in the rather short (11 years) but storied history of Burford Capital, the world’s leading global finance and investment management firm. Ironically, the firm focuses on law yet it was the subject of illegal market manipulation. On that day of trading, an estimated £90 million of sell orders were placed – but canceled. The result of this layering scheme? Its stocks plunged. What may or may be surprising is that they have not yet recovered and, in fact, are trading lower now than they did on that infamous day. The story does not appear to be improving as they issued a 2019 profit warning on February 3, 2020.

The SEC charged
The SEC charged them USA with market manipulation and presented evidence that the pair had masterminded both spoofing and layering schemes

Since 2011, regulators worldwide have invested in systems and crafted laws related to monitoring and flagging high-frequency, high-speed computerized trades. Despite routine updates and enhanced legal definition to critical pieces of financial legislation, such as the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Act) which has implications for traders and financial institutions worldwide, market abuse continues to be documented. Improved data capture, monitoring, and reporting are needed to enforce financial compliance and detect market abuse of all forms, including layering. Traders, exchanges, brokers and financial institutions need to take action now with a complete solution for proactive surveillance, digital compliance, and investigation to improve efforts geared towards the detection of layering.




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