Preventing the next stock heist means beating cyborgs

Preventing the next stock heist means beating cyborgs

It’s a technology arms race that the financial system cannot afford to lose.
It’s a technology arms race that the financial system cannot afford to lose.

Malaysian businessman John Soh Chee Wen and his partner in crime Quah Su-Ling used classic “wash trading” techniques to engineer the biggest market-manipulation case in Singapore’s history.

Wash trading itself is as old as securities markets, but it is becoming increasingly sophisticated as markets become more connected and trading volumes multiply. Quah’s and Soh’s conspiracy, which took nearly a decade to prosecute, demonstrates the scale of challenge that regulators and exchanges are up against today as they try to protect investors and prevent criminal activity in financial markets. It’s a technology arms race that the financial system cannot afford to lose.

The pair did everything they could to put the system to the test back in 2013. Ultimately, they gained control of over 180 trading accounts belonging to 59 individuals and corporate nominees. Their scheme drove three “penny stocks” to climb over 800 per cent in less than a year before crashing again in a three-day period that wiped out about S$8 billion (US$5.8 billion) in shareholder value.

It all comes out in the wash

Wash trades are conspiracies that occur between one or more accounts that a single entity or group controls. Typically, one account will buy an asset from another and then sell it back, or sell it to a separate account controlled by the same people, at a profit. The purpose is to conceal ownership, create artificial trading volumes and – ultimately – to make money at the expense of innocent investors, who remain unaware that the market is being rigged.

By targeting several stocks and spreading the wash over nearly 200 accounts, Quah and Soh hid their manipulation and were able to continue. Using margin financing to trade cash equities, the duo further inflated prices and liquidity in the small-cap stocks. That additional, unusual, movement in the three companies’ stocks was pronounced and hard to explain, which may have been what eventually brought the scheme down.

But what if the duo had been able to commit more capital to the enterprise or targeted smaller movements in bigger-name securities? What if they had set out to manipulate futures, options, bonds and swaps as well as stocks? What if the conspiracy had involved products that trade over-the-counter (OTC) as well as on exchanges? How would it have been identified then?

Trading automation and market technologies have advanced significantly since 2013. Singapore has also strengthened its stock-trading regulations in the years that followed, but fraudsters and money launderers have also been working hard to raise their capabilities and have technology at their disposal, increasing the challenge for market supervisors everywhere.

Arms race

The reality is, regulators are competing with well-funded, technologically-advanced criminals who seek to exploit law-abiding investors. Protecting investors – from working families up to the world’s largest pension funds – requires market supervisors, exchanges and participants to identify connected patterns of suspicious activity across the full spectrum of cash and derivatives asset classes.

Just as any firm involved in financial markets must have ‘Know Your Customer’ (KYC) procedures in place and follow anti-money laundering (AML) rules, they also need surveillance mechanisms to watch for violations.

Today’s challenge is to spot connected activity across different instruments and asset classes. That can be complex when underlying activity is well concealed, but wash trades still leave detectable traces and clues behind. If market participants aren’t looking for them, though, or lack the technology to do it, then those patterns remain invisible as do the criminals.

Advanced financial markets like Singapore’s already have robust capital market regulations and – when abuses are identified – strong enforcement capabilities. It’s not that they need more regulations to prevent a repeat of Quah’s and Soh’s conspiracy; they need to win the tech arms race against criminals to uphold existing regulations.

Manipulators, fraudsters and launderers thrive by flying under the radar. That’s the lesson former Nasdaq chair Bernie Madoff taught the world in 2008, after he hid losses and cheated investors to the tune of US$50 billion. The kind of market volatility we’ve seen recently can provide the perfect cover, too. It’s hard to distinguish “unusual” activity amid outsized market movements and trading volumes: the signal can get drowned out by the noise.

Preventing criminals from pulling off an even more sophisticated and devastating racket than Quah’s and Soh’s could involve connecting activity across hundreds of accounts trading in perhaps dozens of underlying names across equities, derivatives and fixed income.

This kind of endeavour involves finding telltale traces of wash trading and other types of collusive behaviour hidden in an ocean of information. That means the ability to analyse vast amounts of data is essential to catching wrongdoers – but it’s not enough in isolation. That’s because market regulators and participants are effectively competing with cyborgs today: groups of devious humans whose capabilities are enhanced by technology. Those defending market integrity likewise need to complement processing power with the old-fashioned qualities of experience and an eye for the patterns that crooks leave behind. In 2022, a hybrid approach is the best way to stop a new breed of hybrid criminal.

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