End the Silent Treatment: Why Regulators Should Promote Market-Fraud Prevention Efforts

When CFA Institute and a member society, CFA Society Singapore, recently convened a panel of industry practitioners to examine market fraud in the Singapore equity market, what truly amazed me was the number of activities currently overseen by the local regulators’ market surveillance team.

The expert panel featured the chief regulatory officer from Singapore Exchange (SGX), an executive director from a local brokerage, a local independent director, an international lawyer specializing in market-fraud class-action lawsuits, and a retail investor.

The panel initially discussed the definition of market fraud, before going on to explore its origins and what can and should be done to minimize its detrimental impact on market integrity.

Let’s start with surveillance. For its part, SGX uses a surveillance system that triggers real-time alerts. Surveillance analysts review company disclosures, macroeconomic factors, and industry developments that could explain the trading activity.

On average, about 2,000 alerts are analyzed by the SGX surveillance team every month. Normally, only a handful merit further investigation and even fewer eventually develop into full-blown court cases. Nevertheless, 2,000 alerts per month translate to 24,000 alerts annually — definitely not an easy feat even if just 1% is worthy of further investigation.

Although SGX has a market surveillance team in place, it does not have the power to seize documents or interrogate suspicious individuals. That power rests solely with the relevant statutory authorities.

It is not difficult to see that enforcement is indeed a tough and tedious job for SGX to undertake. Would it not be better to remove SGX’s “regulatory” responsibilities and render it a purely commercial entity? After all, that has happened in Australia, where the focus of the Australian Securities Exchange (ASX) is entirely commercial while the Australian Securities and Investments Commission (ASIC) solely regulates.

At first glance, it is naturally appealing to segregate commercial affairs from regulatory duty. After all, this would, once and for all, eliminate perceived conflicts of interest. Upon deeper examination, however, there are two reasons why such a move might be detrimental.

Firstly, it is the bourse that has all the tick-by-tick transaction data essential to investigative work. Unlike staff at the exchange who are dealing with the data on a daily basis, it would be considerably harder for an external regulator to carry out this type of surveillance.

Secondly, it is in SGX’s very own interest to ensure that fairness is optimized within market transactions. As a bourse, it derives revenue from the exchange fees that it collects for every transaction. A market that is heavily tainted by insider trading and stock manipulation would gradually lose the trust of potential investors. Henceforth, its trading volume likely would steadily decline with time. If that were to occur, who has the most to lose? Quite obviously, the answer is SGX.

As an analogy, SGX’s motivation to clean up abnormal trading activities is tantamount to a casino’s desire to ensure there is zero trickery at its gambling tables. In other words, there is an inherent motivation (instead of perceived conflict of interest) for SGX to maintain a level playing field for all investors.

The next question to ask is why SGX’s surveillance activities and regulatory support activities are not well known to various stakeholders at large.

The answer probably lies with the paternal stance adopted by regulators during the inception stage. In Asian culture, governmental authorities are always being regarded as the “fatherly figures.” A father is assumed by his children to be doing the right thing at all times, and no questions whatsoever should be asked. In short, the father typically does not see the need to explain to his children why and what he is doing, and for whom.

Today, however, as we have transcended a prescriptive-based regulatory framework to one grounded on caveat emptor (or “buyer beware”), it is essential for regulators to adopt a more consultative approach in enforcement and policy formation.

There are many advantages for regulators to adopt this consultative approach.

Firstly, getting other stakeholders to understand what regulators are doing, can do, and will be doing renews confidence in market integrity. Indeed, if stakeholders have a say in policy formation and are more informed, they become less vulnerable to market gossip as well as more adept at interpreting corporate announcements. Only then will the caveat emptor principle be meaningful and practical. In other words, you need to “arm” market participants before they are ready to protect themselves.

Secondly, external stakeholders can provide insightful market information to regulators, provided of course they are aware of the proper channel to voice their feedback. As active participants in the capital markets, external stakeholders such as fund managers, analysts, and perhaps even retail investors are in an ideal position to provide regulators with frontline intelligence that I suspect regulators are desperately in need of receiving.

Thirdly, mass media is naturally biased towards reporting sensational events, and where capital markets are concerned, that would typically include market frauds involving astronomical amounts of money, insider trading by prominent figures, and the sharp decline or collapse in share prices.

Fewer media outlets dutifully report on the robust background work undertaken by regulators. Henceforth, it remains the duty of regulators themselves to make known to the world what they are doing and what they hope to change. It’s time to stop working silently.

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Photo credit: iStockphoto.com/miralex