MiFID II and the fight against financial crime

Speaker: Mark Steward, Director of Enforcement and Market Oversight
Location: London
Delivered on: 3 July 2018

Highlights:

• From 3 July, firms require Legal Entity Identifiers[1] (LEIs) before they can trade on behalf of their clients. A LEI is a unique code, included in a global data system, which allows every legal entity or structure that is a party to a relevant financial transaction to be identified, no matter where it is located.
• Since the second Markets in Financial Instruments Directive (MiFID II)[2] commenced on 3 January 2018, our market data processor has ingested nearly 3.5 billion transaction reports, averaging over half a billion reports per month.
• Using software developed in-house to normalise and ingest disparate order book data-sets from the main lit and dark UK trading venues, it is now possible to track potentially related trading activity on different venues and detect cross-market manipulation. 
• We have commenced a small number of investigations into firms’ systems and controls where, for the first time, we have indicated to those firms that we are looking at whether there has been any misconduct that might justify a criminal prosecution under the Money Laundering Regulations. 

Note: this is the speech as drafted and may differ from delivered version.

Keeping our markets safe

Today marks an important step in the implementation of the second Markets in Financial Instruments Directive (MiFID II)[2]. It is the first day in which Legal Entity Identifiers (LEIs) will be required before firms can trade on behalf of their clients, following a six-month implementation period. 

For those of you wondering, an LEI is a unique code that identifies legal entities or structures, including companies, charities and trusts trading on our markets. The code is included in a global data system and enables every legal entity or structure that is a party to a relevant financial transaction to be identified, no matter where it is located.

The requirement for LEIs is the result of one of the resolutions contained in the G20’s June 2012 Los Cabos Declaration which endorsed the Financial Stability Board (FSB) recommendation for the development of a global legal entity identifier for parties to financial transactions “with a global governance framework representing the public interest”. (G20 Leaders Declaration, 19-20 June 2012, Los Cabos, Mexico para 44).

We now have around 130,000 LEIs and over 2.3 million national identifiers that now form part of the MiFID II framework which commenced operation in January this year. 

I want to talk about the way in which identifiers will contribute to our work in keeping our markets safe from abuse and how this extends to tackling the emerging risk identified by the government in last October’s National risk assessment of money laundering and terrorist financing[3], in capital markets and our work here, as well as the importance of some very human capabilities in ensuring any system and control works well.

MiFID II

The change over the last 6 months has been significant.

Since MiFID II commenced on 3 January 2018, our market data processor has ingested nearly 3.5 billion transaction reports, averaging over half a billion reports per month. By contrast, for the first six months of 2017, the monthly average was around 390 million, representing an increase of over 55%.

Previously, we had 8 entities submitting transaction reports to the FCA on behalf of approximately 800 firms. We now have 23 entities submitting transaction reports[4] to the FCA, including 7 Approved Reporting Mechanisms or ARMs (4 are UK authorised and three are European Economic Area authorised passporting the activity into UK); 10 are trading venues and there are six investment firms. Those 23 entities are submitting data on behalf of 3,150 executing firms of which 1,500 are UK firms subject to the Markets in Financial Instruments Regulation (MiFIR) transaction reporting obligations. If we add the transaction reports routed to the FCA from other National Competent Authorities, this brings the total number of executing firms to over 6,000.

And the reports are providing a much more detailed, complex and clearer picture of the market, identifying the buyer, the seller, the decision maker (where applicable), the investment decision within the firm (either an individual trader or an algorithm) and the type of execution within the firm (either an individual trader or an algorithm). 

The additional data has identified a number of anomalies (and we do carry out quality checks) identifying individuals executing transactions who were apparently born in 1900.

We have invested heavily in our technical capacity to ingest, process and use all this information. We are processing 30 million transaction reports per day and we have planned for a 20% increase in capacity and processing of data over 5 years, although there is no upper limit on the ingestion or processing of this information. 

In this context, we are now also asking for and receiving, daily, order book and trade report data from 7 UK trading platform, processing approximately 140 million rows of data per day. There are approximately 70 billion rows of order and trade data currently being stored for FTSE 350 entities for the period January 2013 to April 2017.

This number is likely to increase significantly this year as we have now requested order book data for all FTSE and AIM stocks. Separately, we are also uploading all the data collected under MiFID I which constitutes approximately 20 billion rows of data.

Using software developed in-house to normalise and ingest disparate order book data-sets from the main lit and dark UK trading venues, it is now possible to track potentially related trading activity on different venues and detect cross-market manipulation (i.e. artificially influencing the price of a financial instrument in one market while benefiting in another). Previously this was effectively undetectable, at least not without enormous time and resource.

Global sharing

Importantly, the reports we are receiving are shared with our European colleagues via the European Securities and Markets Authority Transaction Reporting Exchange Mechanism (TREM)[5], giving full value to the G20/FSB objective of identifiers for 'a global governance framework representing the public interest”.  More particularly, since January this year when Mifid II went live, we have routed over 3.1 billion transaction reports to other National Competent Authorities, noting that the same transaction report can be forwarded to multiple regulators. 

In this sense, the framework fosters collaboration across the EU, both now and after Brexit, and encourages local action in attacking global problems.

The framework reflects a global effort from firms as well as regulators, given the substantial investment the industry has made to comply with these requirements and to provide the data in the first place. These commitments and their performance by submitting firms demonstrates a shared obligation to ensure our markets work well, as free from financial crime and market abuse as possible.

All of this is enormously exciting and provides a strong foundation for some ambitious work, tackling cross-border market abuse, including insider dealing, as well as cross-market manipulation far more efficiently than ever before. 

Money laundering in capital markets

Let me now focus on financial crime and money laundering in our markets. Last October, Her Majesty’s Treasury and the Home Office published the UK’s National risk assessment of money laundering and terrorist financing[6] which included, for the first time, the emerging risk of money laundering in capital markets. 

We must act on this and we are.

We have several investigations on foot dealing directly with series of capital market transactions that appear to have no apparent market purpose or function. If our suspicions are right, not only do these transactions falsify liquidity, trading volume and supply and demand in the market, the purpose of these transactions is unrelated to the sale and purchase of the underlying instruments, begging very hard questions. The transactions in these cases also have cross-border elements and they are being conducted in association with regulators and law enforcement agencies both here and overseas.

We have also commenced a small number of investigations into firms’ systems and controls where, for the first time, we have indicated to those firms that we are looking at whether there has been any misconduct that might justify a criminal prosecution under the Money Laundering Regulations. 

I am conscious that starting criminal investigations against firms in relation to poor Anti Money Laundering systems and controls may draw some sharp intakes of breath.

First, the potential for criminal prosecutions for systems and controls failures under the Money Laundering Regulations is a consequence of the regulations themselves and is giving effect to the purpose and intention of the regulations.

Secondly, the prospect of investigations having a dual track, or potentially a multiplicity of outcomes, from no further action to disciplinary, civil or criminal proceedings, is not new and there is already a significant body of practice and procedure in relation to market abuse cases in which the same choices exist.

Thirdly, the fact that criminal proceedings may be brought doesn’t mean they will be brought. An investigation is primarily a fact-finding mission with any decision about what, if any, might result being best left until the end. In short, all the presumptions of innocence apply which is why these firms should not be identified unless and until any charges are laid.

Fourthly, any criminal proceeding will need to satisfy both the evidential test (beyond reasonable doubt) as well as the public interest test. In practice, this will mean that criminal action is likely to be reserved for the more serious cases. 

What will a serious case look like, I hear you ask? It is hard to be definitive. I doubt the depths of seriousness can be fully plumbed anyway. However, it would seem safe to say that where we see what appears to be facilitation of suspected serious crime, in circumstances where plainly obvious checks and questions have neither been carried out or asked, it is likely the test of seriousness will be passed.

In assessing what is plainly obvious, it is important for us to keep in view the significant difference between how something appears both with and without the benefit of hindsight. What is obvious depends on context. 

At the same time, the excuse of hindsight won’t protect a lack of rigour and discipline in the way systems and controls operate; nor the need to ensure systems operate according to their purpose; nor the importance of scepticism and rational intuition to challenge and to ask questions that should be asked and to detect.  

Scepticism, intuition and detection

Systems and controls will not work unless those systems inculcate the ability to ask the right question in a timely way, to be sceptical, to intuit and to stimulate both the ability and the desire to detect.

Professor Eugene Soltes, a professor at Harvard’s Business School, recently published the results of his study on why white-collar criminals do what they do. His book, ‘Why They Do It’ poses the question of why supposedly well educated, well-off, trusted individuals are tempted to lie, cheat or steal. Professor Soltes observes that many white collar criminal '..never deeply felt that the decisions [to commit crime] were actually harmful to themselves or others…' in part because they '…never need to get close – physically or psychologically – to their victims...'In other words, their capacity to understand or intuit the harmful consequences of their actions can be dulled by the fact those consequences are often extenuated by distance or circumstance.

In a subsequent magazine article, Prof Soltes wrote '….in this less intimate world, age-old intuitions are not always well suited to sense the kinds of potential harms that people can cause in the business world' (E Soltes, 14 December 2016, The Psychology of White Collar Criminal, The Atlantic). 

In other words, we don’t notice what we should. I think there is something in this. 

The maturation of systems and controls in firms, the development of global governance frameworks, like LEIs, are vitally important. They become our radar but, and this cannot be overestimated, they are not ends in themselves. Systems and controls helps us know where to look. To work well, we must ensure the clues are noticed, the questions are asked and those who turn the other way are made accountable.  

The question then is: what can we do to ensure our intuitions are better suited to the potential harms that people cause in the business world? 

The fight against financial crime requires a fiercely interrogative mood and no system or control will work well without this.