Market Abuse in Europe: Harsher Penalties for Insider Trading, Market Manipulation
In February, the European Union reached a political agreement to step up the fight against insider dealing and market manipulation across asset classes and trading venues. The European Parliament and the Council agreed to introduce a single definition of unlawful practices together with minimum sanctions, including prison sentences for serious, intentional breaches of market integrity.
The agreement brought an end to two years of discussions. The gist of the agreement: increase convergence of national rules to improve certainty for market participants, update the existing rules to cover alternative trading venues and over-the-counter (OTC) transactions, address abuse in commodities and related derivatives, and raise the game in terms of enforcement and sanctions.
In addition to the objectives above, the rules provide a response to the recent manipulation of interest-rate benchmarks in Europe (LIBOR and EURIBOR): Any behaviour which manipulates the calculation of a benchmark will be considered market abuse, including the provision of false or misleading inputs or information, regardless of the presence of intent or negligence.
The Extent of Market Abuse
There are few insights as to the full magnitude of market abuse in the EU. The LIBOR manipulation affected approximately €7 trillion in loans and mortgages and €250 trillion in derivatives. For equities, the European Commission estimates that market abuse disadvantaged investors by an amount equivalent to nearly 0.1% of market turnover (based on the 2013 market, this would total approximately €8.5 billion).
The Financial Conduct Authority (FCA) publishes statistics on “market cleanliness” which capture abnormal price movements in the two days preceding the announcement of a takeover bid. The good news is that these movements, indicative of possible insider dealing, have gone down from 21.2% in 2010 to 14.9% in 2012, likely due to increasingly vigorous enforcement.
The FCA is the only supervisor in Europe to publish statistics of this kind. And yet, they are limited in scope because they do not capture insider dealing outside a takeover context or any market manipulation at all. Admittedly, coming up with proxies for market abuse is not self-evident, but even statistics on enforcement actions are scarce in Europe, with a startling lack of aggregation.
Good evidence of the importance of market abuse is found in the Global Market Sentiment Survey, conducted by CFA Institute. The survey reveals that market fraud is the most serious ethical issue facing global markets, ranking more important than the integrity of financial reporting, disclosure and use of financial derivatives, and market trading practices, according to the CFA Institute members who offered their input on financial markets, integrity, and performance for 2014.
More Clarity and Sanctions
The EU legislative package will create a single rulebook on insider dealing and market manipulation as well as set minimum prison sentences that member states will have to apply for unlawful behaviours. What exactly is covered?
- Insider dealing covers the use of inside information to trade on own behalf or on behalf of third parties, including any attempt at doing so and the cancelation or modification of orders.
- Any recommendation or other inducement to engage in insider dealing also is unlawful, including for recipients if they ought to know that the recommendation was based on inside information.
- Market manipulation covers any transaction or behaviour which is likely to mislead other market participants, secure an artificial price, or otherwise affect prices using deception.
The definitions in the Regulation are deliberately wide-ranging in an attempt to capture in the future innovative ways of market manipulation, taking into account the difficulties supervisors and judicial authorities often face in gathering evidence and the ever-more complex schemes for deception. Some of those cases have been considered elsewhere on this blog.
However, the definition of inside information was narrowed in the final agreement, compared to earlier drafts, in the interest of legal certainty. Earlier formulations, based on a reasonable investor test, were so ambiguous that they would have endangered shareholder engagement. Inside information therefore needs to be both precise and significant, as to its impact on prices.
Regarding criminal sanctions, member states will need to provide for a maximum jail sentence of at least four years for serious offences committed with intent. The seriousness of an offence will be determined based on the impact on market integrity, the actual or potential profit, and the employment of the criminal in the financial sector or a supervisory authority.
The new rules will put an end to situations where justice was best served in the EU by extraditing those who committed market abuse to the United States, in order to secure tougher sanctions and longer jail sentences — in the words of Arlene McCarthy, the member of European Parliament responsible for the legislation.
Enforcing the New Rules
Supervisors are confident in their ability to enforce the new rules, which they have welcomed. Steven Maijoor, chairman of the European Securities and Supervisory Authority (ESMA), notes that “with robust consolidated post trade information, almost all misconduct can be detected either at firm, venue or market level”. In these efforts, regulators are well assisted by the introduction of post-trade transparency across asset classes and venues by MiFID II.
Nevertheless, it is feared that challenges remain in terms of supervisory and judicial resources and training at the national level. Fraudsters may shop for the jurisdiction where they are less likely to be detected or prosecuted, or where they may face lower fines or sentences. They are also increasingly acting across markets, manipulating one to obtain benefits in another, which is also harder to detect.
What is next?
The rules will be finalised in the coming months, based on the political agreements reached and in alignment with MiFID II. The Regulation on market abuse will become directly applicable, but the Directive on criminal sanctions will need to be transposed and the enforcement mechanisms strengthened. In four to five years’ time, the European Commission will review the efficacy of the legislation, and notably whether common rules for administrative sanctions and an EU framework for cross-border market order book surveillance are needed. The likely answers will be yes to both questions — somehow a missed opportunity not to have tackled these aspects in this reform.
Photo credit: Reuters