Insider Trading scenarios and their detection is a large part of Market Abuse Regulation by ESMA. Our consultancy have been involved in number of projects implementing the coverage for these scenarios for various banks and via various vendors.
Our experience shows that even with so many vendors and surveillance tools on the market, there are very few to no software out there which offers a complete suite considering all details of insider trading techniques. In Addition, no tool can segregate a valid professional trading behaviour from a true insider trading cases. This results in a lot of false hits and increased amounts of “wasted time” in investigation.

Insider Lists vs. No Insider Lists

Should a Insider Trading Surveillance Tool support screening based on Insider Lists or not? The answer for me is that it depends.. If the tool is able to analyse historical trading behaviour of the account/party, then it is not so critical if the tool does not allow adding and screening against insider lists only. In all other cases, it is highly recommended that 1. banks have these lists and 2. These lists can be integrated in the surveillance tool. This makes sure that the investigation time is used effectively with as little false positive hits as possible. However, it is fair to say that many banks in Western Europe have no such insider lists available and ready for use.

Historical Behaviour Deviation Analysis of the Trading Activity

To my mind, this is an absolute must for any insider trading surveillance tool. To understand this, we have to think about what is the pattern of the insider trading. Insider Trading does not take place every day or every week by the same account/party. It usually takes place few times during the year. What happens on these occasions? Insiders go “all in” in to the positions possibly also with leverage e.g. via trading on margin or via leveraged structured retail/non-retail derivatives. Insider trading usually involves multiple exchanges and instrument types. In addition, historical behaviour analysis must involve comparison of the trading activity deviation to that of its peer accounts/parties for the cases where insider has been insider from the day 1 (thus no deviation in the profile). As an additional very beneficial step the tool must have the ability to analyse account’s P/L characteristics and raise alerts for highly improbable scenarios. A highly improbable scenario is for example is when a trading account or party has extremely high win rate e.g. >= 60% coupled with extremely high win/loss ratio e.g. >= 5. This is a scenario which is very likely quite unrealistic for a professional trader to achieve. At the end of the day, who makes money via active trading? Insiders, Professional Traders and those who got lucky on few occasions.

Price Action Analysis vs. News Analysis

If you are asked whether you would prefer using News as a trigger for Insider Trading Event or Price, then my recommendation is very clear to use price. In order to understand this, we have to keep in mind that Price is always the first indicator of accumulation and thus possible insider trading. News is a lagging indicator. It is true that in case of very important announcements such as Mergers & Acquisitions and alike, price makes the “final step”, but usually insiders have long been on the boat maybe weeks or months before. This is why, the tool must be able to analyse price action not only for one day but also for a long times of period and see who has consistently profited from such moves. Our experience using news events as a trigger for insider trading case generation is that the quality of the cases are poor and it is hard to base investigation on this.

An alternative solution would be using a combination of Price and News but it can get so complex that the pros and cons should rather first be analysed very well before implementation. Also, there is a chance of missing out real cases.

Historical Market Volume Analysis?

Should the surveillance tools also analyse market volume in combination with Price Action to define what is an Insider Trading Event? The answer again is it depends..Our practical experience has shown that Compliance Users are better off not using volume as part of triggering even than otherwise. Here is why: If volume is used in combination with price then the Event is triggered only for the days/periods where there was increased price volatility and increased levels of relative volume. (Relative Volume = Today’s Volume / Average Volume on the Market). Now, the problem with this approach is that 1. one might miss out other dates 2. On these key dates with strong price/volume action, the professional traders are more likely to participate in the market than the insiders. Surely, it can be that the insiders started the wave of activity and then Price Action traders joined the party, but it is far more likely that Insiders trade quietly on “non-key” dates and times.

Multi-Exchange-Instrument Analysis?

Insider Trading Surveillance tools must absolutely be able to analyse trading activity on multiple exchanges and multiple instruments. For this purpose, the tools should not limit the triggering of the event on single account/exchange/product basis but rather higher level of analysis.

With that said, we are coming back to the historical behaviour analysis topic. Ideal solution must be starting analysis with “too good to be true” key ratios such as Win Rate and Win/Loss Ratio on the level of the party/beneficial owner with no limitation to a single exchange or instrument. The latter assumes that either the vendor or the bank can provide a master-file of mapping between derivatives and underlying. Without this mapping no multi-exchange-instrument detection is possible.

After Market Event Analysis?

A highly overlooked area of the analysis of Insider Trading Scenarios is the After Market Event Analysis. Here is the question, what is a typical behaviour of the Insider vs. Non-Insider after the Market Even has occurred and the price moved significantly in the direction of the position? A Professional Trader knowing his own targets and stop losses is far more likely to be understanding that this particular price jump is a result of the overreaction to the news on the market and thus non-sustainable and thus it is more likely that he will close his position and take profits during the day, possibly, very near in time to the price action. Whilst, Insiders and also those who got lucky will hope that this action will continue non-stop and will decide to leave the position open and wait. These are so called “weak hands”. At the first instance of the opposite price action to the original direction, “weak hands” will get shaken and they will drop out of the market.

Another important between professional traders and insiders is the technique of exit from the position. They way Professional Traders exit is far more likely to be per Limit Order whilst insiders are far more likely to be exiting per Market Orders.

Undetectable Case?

In the end, there are probably also undetectable cases. Imagine a situation where an Insider is at the same time a professional trader. I think, these are cases which are extremely difficult for compliance officers to prove since it would require compliance officers to be as good at understanding of Market Structure and Trading as the Traders themselves, which is quite uncommon.

If you are interested to hear more about this, please, let us know. Via our trainings on Market Abuse you can get to know the methodology.

Kind Regards,

Gio Kevanishvili Consultancy