False Disclosure Rules
False disclosure rules are distinct from insider trading rules and may or may not be specifically enumerated in securities laws and/or within an exchange's rule book. For instance, market participants might actively distribute false or misleading information that has the effect of distorting the marketplace. False disclosure can be carried out by a broker or client independently and does not require trade execution or a change in beneficial ownership. It does not violate price/time priority but does mislead price and volume.
Parking or warehousing refers to the failure to disclose information, such as the mandatory disclosure of ownership interests above a certain threshold level, which is typically set at 5 percent in many countries around the world, by having third parties controlled by an individual or associates trading in their names. Clients initiate parking/warehousing, but it may be done in collusion with a broker. Parking/warehousing requires trade execution but it does not require a change in beneficial ownership or violate price/time priority. Clients benefit from parking/warehousing, but it does not directly affect price or volume.
Overall, this section refers to trading rules on price manipulation, volume manipulation, spoofing, and false disclosure as the market manipulation rules. Cumming, Johan, and Li (2011) aggregate these rules to form separate indices for each, which they call subcomponent indices. They then combine them in their sum total to form the Market Manipulation Rules Index. These indices are considered separately from insider trading rules and broker-agency conflict rules, which form the other two primary indices.
Broker-Agency Conflict Rules
Brokers act on behalf of clients but can do so in ways that are against client interests. This type of principal-agent problem may arise from a broker's failure to obtain the best price for a client, which is commonly known as a breach of a trade through obligation; brokers may favor trades with affiliated brokers, the broker charging excessive fees (improper execution at unreasonable costs) or acting in ways that are generally detrimental to client interests such as by investing in securities that do not match the client's risk/return profile, which is referred to as breach of the know-your-client rule. Trade-throughs are initiated by colluding brokers, where trades involve a beneficial change in ownership and a violation of price/time priority. The broker benefits, but no direct adverse price of volume impact takes place. Improper execution is initiated by independent brokers, not necessarily colluding, where trades involve a beneficial change in ownership but without necessarily violating price/time priority. Here, the broker benefits, but no direct adverse price or volume impact occurs. Brokers might also use the exchange's name improperly in marketing their services or carry out other forms of improper or unethical sales and marketing efforts. For broker-agency conflict rules, Cumming et al. (2011) use information explicitly indicated in the rules of the exchange, and not guidelines from professional associations such as the Chartered Financial Analysts' ethics guidelines and the like.
Cumming et al. (2011) summarize all the different types of manipulation described in stock exchange trading rules. The trading rules for a stock exchange are drafted with varying degrees of specificity as they outline the exchange membership requirements, listing requirements, trading rules and regulations, and especially prohibited trading practices.
Each of the different rules for insider trading, market manipulation, and broker-agency conflict described in the exchanges' trading rules are weighted equally in the indices reported in Cumming et al. (2011). The Insider Trading Rules Index comprises 10 items. The Market Manipulation Rules Index encompasses a total of 14 items, which include price manipulation (seven items), volume manipulation (two items), spoofing (three items), and false disclosure (two items). The Broker-Agency Conflict Rules Index comprises five items. The indices in Cumming et al. summarize the degree of regulation in a country before and after the changes brought about in Europe with the Lamfalussy Directives, which encompass both MAD and MiFID.
Cumming et al. (2011) find evidence consistent with the view that more detailed trading rules are associated with greater market liquidity, in the spirit of early work ranking the quality of exchanges around the world (Aitken and Siow 2003). Cumming et al. use an international sample of countries, including some but not all in Europe, and use the pan-European wide regulatory change as a natural experiment to study the effect of a securities regulatory change on liquidity. They find strong evidence of a positive impact of the market abuse rules enumerated earlier.
Christensen, Hail, and Leuz (2016) study the same regulatory change as in Cumming et al. (2011), even though email correspondence with Cumming et al. shows that Christensen et al. did not realize that the regulatory change they examined involved changes in trading rules. Cumming and Johan (2019) document their lack of understanding about the regulatory change, among other things. Christensen et al. use a set of European-only countries, and likewise show a positive effect of the regulatory change on market liquidity. They also use slightly different dates than Cumming and Johan in their contribution to the literature.
Similar to work showing that trading rules improve liquidity, other research is likewise consistent with the view that stronger trading rules, surveillance, and enforcement affect the trading location of cross-listed stocks (Cumming, Hou, and Wu 2018) and curtail suspected insider trading activity (Aitken, Cumming, and Zhan 2015a) and end-of-day manipulation (Aitken, Cumming, and Zhan 2015b, 2017).
SURVEILLANCE
A necessary first step toward enforcement of securities laws is surveillance (Domowitz 2012). Put differently, without surveillance, no enforcement of trading rules occurs. Surveillance refers to automated computer algorithms that are used to detect manipulative trading patterns identified earlier. Surveillance algorithms send messages called “alerts” to staff that work at securities commissions or the authority that governs the particular stock exchange. The alerts are in real time, meaning that market abuse is detected immediately. With one-time behavior, a manipulation might lead a surveillance authority to call the trader(s) involved for an explanation. Normally traders have an “alternative plausible explanation” (APE) to explain why they executed the trades in question. However, with repeated pattern behavior, the surveillance authority can more easily prove misconduct and pursue a legal remedy.
Computer software providers, such as SMARTS Group, Inc., had provided software to over 50 exchanges around the world before being acquired by NASDAQ in 2010. Such software customizes its system to manage the type of alerts provided to surveillance staff. Such customization is necessary as each exchange or securities commission around the world differs in scope and requirements for surveillance. The set of alerts in conjunction with manipulative practices depicted in Cumming et al. (2011) is comprehensive for most surveillance systems. These alerts apply to both single-market manipulations and cross-market manipulations. Cross-market surveillance refers to surveillance across different products, such as equity and a related option on the same underlying equity, and across markets or different exchanges or different countries. Cross-market surveillance is much more technical to perform and execute in terms of computing power.
Moreover, cross-market surveillance requires information-sharing agreements across exchanges. Cumming and Johan (2008) present evidence from 25 markets around the world, showing that many exchanges in Europe did not have effective market surveillance at the time of the national implementation of MAD. However, such surveillance was in place around the time of MiFID. As such, Cumming and Johan (2019) are highly critical of derivative work (Christensen et al. 2016) that replicates earlier studies of the impact of market trading rules on market liquidity (Cumming et al. 2011) using MAD adoption dates and not MiFID adoption dates.
The effectiveness of the surveillance systems in different jurisdictions around the world depends on various factors