In the latest edition of Market Watch, the UK Financial Conduct Authority (FCA) discusses its observations and findings from its recent market abuse peer review into firms that offer Contracts for Difference (CFDs) and spread bets.

The FCA notes that CFDs and spread bets are particularly vulnerable to being used for insider dealing due to the speculative and leveraged nature of the products. They are a major source of Suspicious Transaction and Order Reports (STORs).

The regulator says it is also aware of a potential increase in a type of manipulative behaviour where spread bets and CFDs are being used to realise profits following manipulative practices in the underlying market via other firms.

To select the firms for the review, the FCA analysed firm data and selected nine firms in total. The FCA asked them for information about their business models, market abuse risks and arrangements for detecting and reporting market abuse. The FCA reviewed documentation including policies and procedures, risk assessments and relevant management information. The regulator then undertook supervisory visits to seven of the firms to look at their risks and controls more closely.

The overall findings from the peer review were largely positive. All firms have surveillance in place to detect insider dealing, most of which the FCA considered effective.

The regulator did observe some weaknesses, such as the lack of consideration of market abuse risks in non-equity asset classes and market manipulation, leading to gaps in surveillance.

All firms recognised insider dealing in single stock equities as the predominant market abuse risk. However, not all firms could demonstrate they had considered all market abuse risks relevant to their business. Firms that could do so had a market abuse risk assessment which documented that they had considered different market abuse risks. Two firms had documented an assessment of the policies and procedures for market abuse, rather than an assessment of the market abuse risks applicable to the business.

All these firms offer CFDs and/or spread bets in non-equity asset classes, but there was little consideration of these in their market abuse risk assessments and limited detail about market manipulation in all asset classes. Two firms split out different types of manipulation in their risk assessments, considered how the risks differed depending on trading platforms and trading method and documented why specific risks were less relevant for their businesses.

A focus of FCA’s review was ‘narrowing the spread’, a type of market manipulation that the regulator believes may be increasing. This activity aims to influence the prices of spread bets or CFDs by narrowing the spread in the underlying market, typically in illiquid stocks.

Orders are placed on the order book via a DMA broker (using either CFDs or cash equities) to buy (or sell) a security at prices higher (or lower) than the current best bid (or offer). This narrows the spread of the security and leads to a change in the execution price of the CFD or spread bet, which is based on the underlying instrument. The same (or connected) participant then trades in the opposite direction, in larger size, in a related derivative such as a CFD, often at another broker, benefiting from the improved price. The DMA order is typically cancelled before it trades.

Some firms were not aware of this activity, but most were, with some having submitted STORs. However, no firms had listed this behaviour in their risk assessments or had Compliance-based surveillance to detect it. Trading/hedging desks which monitor profit were sometimes directed to flag the activity to Compliance. One firm’s trading desk used reports to trigger alerts where clients were consistently making profits opening and closing positions in a short time frame.

The FCA urges CFD brokers to take steps to ensure that their systems and procedures for detecting and reporting potential market abuse are appropriate and proportionate to the scale, size and nature of their business activities. Firms should also ensure they have effective policies and procedures to counter the risk they are used to further market abuse-related financial crime as per SYSC 6.1.1R.

The regulator says it will continue to visit CFD providers and other firms to assess their STOR arrangements and work to ensure they meet their regulatory obligations.