Typical compliance issues

The following are examples of compliance issues that can often lead to significant
problems (ignoring the obvious example of insider trading):
Ω Lack of notification
Ω Focusing exclusively on a transaction and not the aggregate effects
Ω Miscommunication internally
Ω Unwillingness to admit error
Ω Lack of planning
Ω Fragmented internal oversight
Ω Failure to segregate customer and proprietary trading
Ω Failure to enforce basic rules
Ω Failure to follow market changes
Ω Failure to link system reports
Ω Multi-tasking of compliance
Ω Failure to track competitor activities
Lack of notification may lead a firm to be unaware that a compliance event has
occurred. Businesses typically focus on sales volumes or profits. What many in a
large corporate family overlook is that positions and actions are often aggregated
across related companies for regulatory purposes. A related affiliate may be active
with the same customer or use the same futures contract. These positions might
need to be aggregated for purposes of complying with contract reporting or contract
position limits. Alternatively, special regulatory filings may be triggered unless
regulatory exemptions can be obtained.
Business people often focus on transaction specifics and may overlook the marginal
impact on existing portfolio(s). The purchase of a specific bond may be entirely
prudent. However, the regulations or internal policies and procedures might have
credit concentration limits or country basket limits. There might well be enough
room under the credit line for the particular obligor but the transaction runs foul of
various macro limits. If the deals are not properly coded in inventory systems then
country limits or currency limits may be unknowingly breached.
Miscommunication often occurs when people lapse into jargon. In one company,
managers using futures have confused reporting limits with position limits. As a
result, they used a less appropriate futures contract to hedge an exposure since they
mistakenly thought they were nearing a position limit for a specific futures contract.
This can result in an economic cost of executing a suboptimal hedging strategy. In a
related occurrence, an external auditor disallowed favorable accounting treatment
for short positions in futures. Short hedges were not utilized by the company until
the external auditor later corrected the restriction so it would be applied properly
only to naked ‘short sales’.
Business people are often unwilling to say ‘I don’t know’ or ‘I made a mistake’. A
trader might err when trading a position with a broker. In order to hide the error, he
arranges with the broker to ‘correct’ the price. In turn, the trader directs new business
to the broker to pay for the favor. Several large derivatives losses have occurred as a
result of a trader speculating in the market to hide a previous error. In the late
1980s, ABN’s New York branch had a FX options trader that executed sales instead
of buying FX call options. The trader attempted to ‘trade out’ of the mistake and
eventually lost more than $50 million.

Simply not planning ahead with compliance can trigger problems. Traders often
focus strictly on the economics of a transaction to the exclusion of regulatory
requirements. They may wait until the last minute to consult with compliance. In
the heat of battle during a trading day, traders may not inquire about the rules since
there is time only for reflex action and not for reflection. A preventable violation may
ensue and corrective action must then be undertaken.
Compliance areas sometimes exercise fragmented oversight and there is a danger
that compliance staff becomes too specialized. They may be focused strictly on the
requirements of securities law or commodities law and fail to see the full range
of other regulations that may apply (e.g. pension money typically invokes ERISA
regulations). There may be filing or disclosure documents that are triggered. Simply
focusing on product-related compliance does not ensure success in satisfying complex
entitywide regulatory requirements or customer disclosure requirements.
Failure to segregate customer and proprietary trading leads to the abusive practice
of front running, i.e. knowing a customer’s order and trading in the market ahead of
the customer’s trade. It is an ethical violation as well as violation of the fiduciary
relationship that is created when a firm acts on behalf of its customer. An equally
insidious practice is when a trader can execute for both a firm’s account and
customer accounts. Unless there is strict compliance control, losing trades have a
tendency to wind up in the account that best suits the trader’s compensation scheme.
A trader of Canadian Governments at a New York money center bank had trading
authority on a proprietary book as well as on clients’ behalf. The bond clearing was
done in Canada, the accounting in the UK, and trading in New York. The trader hid
losses in customer accounts and eventually cost the bank more than $50 million in
unauthorized trading losses. The division of controls in three geographic locations
certainly played a role as well.
Failure to enforce simple rules and deadlines tends to lead to larger violations.
Non-cooperation on the part of the business people with compliance is a frequent
experience. If the business people are not required to abide by filing or reporting
requirements, they may be enticed by gaps in oversight to violate more significant
compliance guidelines.
As products and markets change, the type and range of compliance requirements
will change as well. Frequently, business people will rely on documents that were
negotiated and signed years before. Market practices could well have changed and
the document no longer reflects best practices or current market conventions.
Failure to link systems reporting to all functional areas leads to gaps in oversight.
Incompatible systems where manual reentry of data occurs is a companion issue.
One large derivative dealer started to trade credit derivatives and the transactions
were reported to all departments except the risk department. The risk unit was
caught by surprise since the risk module report had not been linked-in. The risk
unit knew that the product had been approved but were never notified that trading
had actually started until a small portfolio had already been created.
When compliance units are charged with other duties, compliance may lose its
focus. Production duties tend to get priority since they typically have pressing closing
schedules. Frequently a compliance area may be doing a review just prior to the
deadline. This tends to result either in an incomplete or hurried review which creates
the opportunity for more errors to occur.
When a competitor makes a high-profile error, the regulators will often focus on
the same issues in their next review Given the public awareness of the type of error
made, regulators will often apply a higher standard of evaluation if they encounter a
similar problem in the organization. This may occur even if no updated legislation or
regulations have been enacted. Regulators typically can discover large compliance
problems in a variety of ways: newspaper story, trade journal comments, competitor,
disgruntled employee, aggrieved customer, private litigant, or auditor contact. 499