Brokers Need to Monitor Market for Cheating in Era of Flash Crash

NEW YORK (TheStreet) -- Between high-frequency trading, the flash crash, the recent Avon bid hoax and myriad other events, sometimes the capital markets can seem rigged for the average investor. The SEC and other regulators always seem one step behind those who could gain by cheating -- and often do. What can be done?

Brokers need to do a better job monitoring their own traders and trades for shady activity, to stop it before it becomes a problem.

Compliance today has become synonymous with regulatory bodies, but playing by the rules isn't merely about appeasing federal agencies and avoiding fines. Surveillance by brokerages and trading firms is crucial to making sure traders aren't distorting prices or violating policies that negatively impact the market (and, as a result, disrupting market efficiencies).

Preventing the Next Flash Crash

On the day of the Flash Crash, five years ago, the Dow Jones average dropped 600 points in less than seven minutes; stocks lost $1 trillion in value. It wasn't until last month, however, that a young London-based trader was arrested for contributing to the crash, as well as profiting from other illegal trading maneuvers since 2009.

The trader's involvement in the crash comes down to "spoofing," a manipulative tactic in which fake trades are submitted and subsequently cancelled in order to bias a stock's price. This type of scheme often leads innocent traders to mimic the fake orders, further skewing the perceived stock value.

It's a lofty ideal to expect a regulatory body, let alone an individual firm or trader, to detect one instance of spoofing on the one day when it will trigger a major market crisis. Rather than treat citizen surveillance as a one-off activity, professionals throughout the industry need to view surveillance as an ongoing responsibility.

Market surveillance isn't about what happened yesterday, or even what will happen an hour from now. It's about examining patterns over time to expose the malicious activities traders are currently testing or polishing. Just like common criminals who start small (for example, stealing candy from a local drugstore before graduating to larger retailers and banks), manipulative traders don't expect to instigate a market crash on their first try.

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