Best market surveillance product: Nasdaq SMARTS

Operational Risk Awards 2017: Breadth of coverage helped Nasdaq clinch award

Ayo Arije, Nasdaq

Surveillance of trading operations has never been more onerous than it is today, as the pressure from successive market abuse scandals and heightened regulation bears down on financial institutions. In these circumstances, firms need a platform that can adapt to new rules, fit every type of organisation, and keep pace with fast-moving trends through innovative technology. Nasdaq SMARTS Surveillance fits the bill.

“Investment banks and broker-dealers have all of these different siloed data channels,” says Michael O’Brien, vice-president of product management, global risk and surveillance at Nasdaq. “They typically don’t talk to each other. We have been talking with customers who have noted there is value in bringing some of these data silos together to provide additional context and insight.”

The SMARTS product has evolved at a time of increased surveillance requirements on both sides of the Atlantic. In Europe, the Market Abuse Regulation came into effect in July 2016, tackling insider trading and more pernicious market manipulation practices such as spoofing. From January 3, 2018, Mifid II will demand much greater monitoring and reporting at the trading desk level.

Meanwhile in the US, existing rules for dealing with abusive trading in derivatives and equity markets are likely to be augmented by an anti-disruptive trading rule, which then commissioner at the Securities and Exchange Commission, Mary Jo White, said in 2016 was planned for 2017. She cited concern about the use of a “destabilising short-term trading strategy during a period of market weakness” evident in flash crashes. The Department of the Treasury consulted on an anti-disruptive trading rule for the US government bond market at the start of last year and Regulation Automated Trading includes similar provisions for the derivatives market.

Faced with the need for more granular monitoring of trading activities, many firms may need to adapt their systems and infrastructure. For large firms, getting to grips with the data needed to comply with new rules, and building the flexibility to adapt when heightened requirements are imposed, places considerable strain on entrenched legacy systems.

SMARTS uses sophisticated pattern-based alerting to track activity, while minimising false positive rates. The judges praised the system’s ability to handle a large number of scenarios across many markets and products and tackle a range of stakeholder needs, spanning buy-side and sell-side firms, regulators and market infrastructure operators. 

“The product recognises the shift towards holistic surveillance to integrate other information and towards trader profiling,” noted one judge. “[It] correctly aims to shift from post-event to pre-crime management. Finally, there is strong brand confidence for longer-term support and stability.”

The trend away from a regulation-specific focus to monitoring individual behaviour, favoured by Nasdaq and with traction amongst several customers and judges, has enabled market participants to create a framework in which adherence to specific regulations can be tracked, but also expanded as new rules come into force. It moves towards more holistic monitoring of activity that is suspicious, creating more flexible surveillance. To do this, the system takes a contextualised view of activity.

“We have built within SMARTS an integrated trading profiler known as ‘Lens’, which tracks a trader’s performance relative to the entire market as well as his/her peers,” says O’Brien. “Generally, strategies which are successful get arbitraged back to more normal returns. Where substantial outperformance is maintained over a period of time or anomalous spikes in performance take place, accompanied by shifts in order-to-trade ratio and churn rates i.e. increasing trading volumes, this can signal trading scenarios where non-public and price-sensitive information is being used, or can signal potential spoofing or layering trading patterns.”

The focus that Lens offers can also be beneficial beyond the trading desk. Buy-side firms are interested in deploying the trading profiler so that they can look for anomalous performances at the portfolio manager and executing broker level, says O’Brien. Most hedge funds and asset managers are at an earlier stage than dealers in their use of surveillance technology, as in many jurisdictions dealers have longer-standing requirements to report client activity.

“At the moment they are taking monitoring out of internal tools and spreadsheets, and starting to integrate monitoring into a systematic way of looking at their trading,” says O’Brien.

Nasdaq SMARTS monitors multiple data sources and communication channels, pulling the results together to build the profile. SMARTS Profiler, which is powered by Digital Reasoning, a specialist in cognitive computing that Nasdaq SMARTS partnered with last year, can track anomalous changes in the way traders communicate.

The next stage in the evolution of SMARTS will be the integration of advanced machine learning to provide an even more nuanced service that points analysts in the direction of the alerts and flags on which they should focus their attention.

“The idea of integrated profiling is to bring together these flags being generated from the trading and communications profilers,” says O’Brien. “For example, identifying that a trader has substantially outperformed the market and this behaviour has coincided with a change in asset classes traded as well as a shift in the manner in which this person communicates. We start looking at using artificial intelligence, clustering techniques and so on to spot these data points as risk points, which we then map to behaviour.”