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Conduct Risk: Compensation

Conduct Risk: Compensation

Nicolas Corry, Managing Director, nicolas.corry@skadilimited.co

It’s the time of year when the compensation for Financial professionals is brought sharply into focus. Regulators are driving for compensation to be linked to long term profitability and conduct, recognising that hard pay out structures and incentive schemes may encourage short termism. However significant gap risk persists. Sell side staff increasingly find that their compensation is pushed further down the line, with lengthy vesting periods, and the threat of claw backs to pay should staff be found guilty of wrongdoing (malus).

Across the street from the Traders and Investment Bankers, who capture most of the headlines, there are market participants with compensation models that are moving sharply in the opposite direction. Interdealer Brokers are a prime example of parties who’s compensation model is becoming harder. Their pay model has moved from salary plus bonus to one that is “eat what you kill”. Salaries have been switched for draws which are effectively small bonus advances, with quarterly bonuses determined from high hard percentages ranging from 35% – 65% of profit generated. This juxtaposition heightens the risk of trading staff directing business, and over trading, with the goal of sharing revenue generated with the broker.

Joint Ventures also pose a risk where other parties in a JV are compensated in a hard manner for business brought in. An example may be a broker, or hedge fund, charged with sourcing “cheap” packages of securities. Trading staff may be lured into turning a blind eye to less profitable, or even loss making trades at the expense of the trading book, if they are able to monetise activity through their relationship with a party within the JV who’s payout structure is hard.

We recommend our customers identify businesses using Interdealer Brokers (wide-spread) and Joint Ventures. They should establish what line of sight Front Office Management have over trading activity, and whether reviews/monitoring are in place to identify broker concentration risk, whether traders are awarding excess brokerage and whether this is appropriate. In the case of Joint Ventures, control functions should review the terms to judge whether there are opportunities for parties to extract up front revenue under the terms of the arrangement.

Conduct Risk: Colloquial Trading Practices

Conduct Risk: Colloquial Trading Practices

Nicolas Corry, Managing Director, nicolas.corry@skadilimited.co

Our customers constantly ask us where the next area of focus for Regulators will come from. Our predictions are that regardless of the product or market, poor conduct will be at its heart. The Fair and Effective Markets Review devotes a large part of its scope to the subject of Conduct Risk. Conduct Risk emerges from a number of powerful drivers which are challenging to define, recognise and control. A key challenge Control Functions face is how to manage Conduct Risk effectively without constraining Front Office innovation and creativity.

Skadi Limited has defined an area of risk: Colloquial Trading practices. We define these as practices traders use in their day to day activity, at best, not governed by rule structure, at worst, unknown and unrecognised by outside observers which include Management, Control and the Regulators. Examples are Last Look (now identified), No-post Trading, Grey Market Trading.

No-post trading is the practice whereby traders ask the Inter-dealer Broker and the Counterparty on the other side of a trade to agree not to broadcast the trade to the wider market place, preserving the secrecy of the transaction. Justifications for this may include an instrument being highly illiquid, when knowledge of the transaction may impact the market price for a security. The practice could be misused however. Risks include front running, creating a false market.

Grey Market Trading is dealing in a new security prior to its terms being fixed. Grey Markets are intrinsically linked to the success of a new issue placing, it is paramount therefore that members of syndicate do not trade in the Grey. Securities trading above issue price will attract orders into the book, it may also be attractive to sell into the Grey Market price to reduce the price of a security to protect the Syndicate from accusations that the terms offered to the market were too generous to the disadvantage of the Issuer. Grey Market Trading mainly occurs via the Inter-dealer Broker market, and a Grey Market may develop over a number of days, it can be difficult to track trading activity as the securities generally are not set up until the terms are known, allowing trades to be parked for a few days, and booked out at a later stage. To date we have not found regulation covering Grey Market Trading, therefore the practice is also at risk from ethical drift as new traders over time may not be aware that their participation as a Syndicate member is wrong.

We recommend our customers establish to what extent “Colloquial Trading Practices” are recognised by Front Office Management. Whether the practices have been reviewed for their application in the current market environment. c.f. last look trading borne out of a legitimate historic need but now no longer acceptable to advances and changes in the market place. Audit and Compliance need to ask Front Office to demonstrate and provide justification for their legitimate use and assess whether they are appropriately controlled.

Taking a forward look today, could help prevent a “Last Look” tomorrow.