How experienced are your compliance vendors?

It’s vital to have a trusted advisor to verify what vendors claim

Watching this video hosted by Victor Anderson, Editor-in-Chief of Waters Technology, on The Buy-Side Challenges of Complying with the Market Abuse Regulation (MAR) is a salutary reminder of the need to apply the right skill set in compliance.

Elinor Murray, Head of European Compliance at Legg Mason makes an excellent point:

The vendors who are developing the systems perhaps don’t have that practitioner experience and/or input and therefore one can potentially end up with a solution that doesn’t quite work from a usability prospective”.

Gautam Sachdev, Global Head of Monitoring & Surveillance at Macquarie Group, adds:

“You actually need staff who have had experience in the sales and trading capacity of the particular asset class, to be able to look at it from that angle, because not everything is vanilla equity, especially if you are looking at some of the structured products, when you’re looking at commodities and OTC markets in particular.”

I couldn’t agree more. In order to produce useful trade surveillance solutions, compliance vendors need to have a level of experience/understanding of the asset classes and instruments that is at least on par with the traders whose activity they are trying to surveil.

But in my time working in the industry, I have seen vendors licensing their solutions to surveil asset classes and financial instruments for which they had no practitioner experience or product knowledge. This resulted in their solutions producing alerts that compliance end users labeled as nonsensical or useless. Many issues are caused by vendors adopting their legacy equity solutions to work for other asset classes without having a strong understanding of the differences between equity and other asset classes.

One vendor I came across was licensing its platform and models to surveil trade manipulation for Fixed Income (FI) asset class and FI derivatives and was claiming to be an expert in swaps. Yet

  • that vendor’s platform and models could only support prices expressed in currency value.
  • The software and platform didn’t support prices expressed in any other terms such as yield or basis points. Incidentally, FI derivatives such as Interest Rate Swaps(IRS) and Credit Default Swaps(CDS) can only be priced in yield or basis point terms (1bps is equal to 0.01%). Plain vanilla fixed-floating IRS swap prices reflect the yield or interest rate of the fixed leg of the swap. Basis IRS swaps are priced as a yield difference, expressed in basis points, between two floating legs of the swap. CDSs are priced in bps and constitute a percentage of a notional insured amount that is paid yearly by a CDS buyer to a CDS seller.
  • It was impossible for the models to simultaneously surveil FI derivatives and be unable to support prices expressed in bps or yield terms.
  • The vendor’s models produced alerts for FI swaps with prices shown in USD, instead of showing prices as yields or bps. Although it may seem to be a simple display issue, this shortcoming reveals the importance of having vendors with practitioner experience, and it warrants questioning the vendor’s general ability to surveil the FI asset class and its derivatives.

Another shortcoming of that vendor’s platform was the fact that it only allowed CDS to be linked to one underlying bond. This was most likely carried over from their equity model where a given equity option has one underlying stock. In the FI world, CDS protection is usually written against the tranches of debt (multiple bonds) issued by one corporate entity or one sovereign nation.

  • Since the platform wasn’t capable of linking one CDS to multiple bonds of the same entity, it could miss cross-product manipulation alerts. This is the subject of my article on MAR cross-product manipulation market abuse behavior.

So how do you make the right choice and protect your business from vendors who claim what they can’t actually substantiate? The 2019  Aite group Trade Surveillance and Monitoring Solutions report suggests that buyers do not

“make purchasing decisions based solely on vendor claims and demonstrations. Invest time and resources in independently verifying functionality, coverage, and performance by conducting extensive reference checks, product testing, scenario analysis, and as much back-testing as can be made available. Additionally, commissioning an independent analysis during the request for proposal (RFP) process is more than worth the investment, as that service will often cover a decent portion of the necessary vetting.”

I strongly suggest heeding that advice. It is important to have a trusted advisor verify your vendor’s claims about their models, by putting the models through test cases developed by experienced compliance professionals. It is paramount that your institution does not blindly rely on your vendor’s claim that their models meet regulatory requirements, but rather has independent and experienced advisors verify those statements. The price of reputational damage and regulatory fines far exceeds the small and imperative investment needed for this independent, professional review.

This article is written by Boris Sherman, senior business analyst in our Financial crime & compliance team.

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Joseph Cataldo

Managing partner

I help our clients tailor, implement and remediate all aspects of anti money-laundering, customer due diligence, trade surveillance and suspicious activity transition monitoring