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.

Firms need to do a better job of sniffing out the relative activity to determine whether or not traders are a potential threat to their business or market. Critics have been quick to blame regulators and even the trader's broker (MF Global) for inadequate surveillance, despite warnings from exchanges. Looking back, the trader in question was likely testing out his spoofs days or weeks before the main offense, and could have been caught earlier with proper analysis.

For broker dealers and trading firms to practice this good citizen surveillance, they need stronger tools. Spreadsheets alone are not nearly enough to keep up with the high-frequency trade algorithms that pervade today's markets.

Capital markets businesses have to shift some of their focus to back office resources. (Disclosure: my company, Firm58, provides back-office software for brokers and other financial firms.) With the right post-trade solutions, firms can monitor trades across multiple platforms and exchanges, and flag questionable activities in a centralized location. More importantly, companies reduce both the time and effort required to pinpoint devious activity by automating the surveillance process and compiling observations in a digestible, digital format.

In a sector as fast paced and volatile as the capital markets, compliance duties can't be the purview of one compliance officer, one organization or an agency -- everyone has to have a hand in monitoring their environment. The more companies that adopt this attitude (and invest in the systems to accommodate it), the safer all involved parties will be.

The day-to-day intricacies of the capital markets industry can seem daunting to the uninitiated. But, on some level, capital markets depend on the same principles and ethics as society at large in order to operate efficiently.

This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.

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