The interim order passed by Sebi in the Axis Mutual Fund’s front-running case provides a clear picture of the misalignment of behavioural incentives. The chief dealer of the fund exploited his insider knowledge to trade securities ahead of orders placed on behalf of the MF. His personal trade positions were squared off soon after placing the MF order.
The global banking sector has faced similar ethical challenges, particularly in the spot gold and Libor benchmarks. Bank officials allegedly manipulated the London Gold Fixing and Libor to benefit their trading positions or appear more creditworthy. Libor and London Bullion Market Association (LBMA), gold fixing processes, have been found vulnerable due to their reliance on expert judgement.
To address this, regulators implemented a two-pronged approach:
LBMA gold fixing transitioned to a system based on actual, verifiable trades facilitated by the ICE Benchmark Administration (IBA).
Secured overnight financing rate (SOFR), a more objective benchmark, is now calculated and traded in the markets, replacing the manipulation-prone Libor. This reduced reliance on subjective expert judgement and strengthened oversight and enforcement mechanisms to deter future manipulation attempts.
Sebi has also implemented measures to curb these unethical practices. These steps focus on integrity, transparency and accountability. The regulatory framework has laid down provisions under a code of conduct for AMCs, and fund managers and dealers (FMD), who are also prohibited from indulging in unethical business activities or professional misconduct.
To institute a robust risk-mitigation mechanism, MF regulations proposed:
Establishing a structured institutional framework to identify and deter potential abuse.
Enhancing the responsibility and accountability of AMC for implementing and overseeing this institutional mechanism.
Fostering transparency through a whistleblower policy.
The root causes of unethical behaviour in MFs stem from misaligned incentives and information asymmetries. A multifaceted approach is necessary to address these market abuse practices. Here are some suggestions:
Rating system: Implement a robust rating system for MFs based on performance and AUM, but also on their adherence to ethical standards and compliance history. This would give investors a more unambiguous indication of the fund’s integrity.
Penalties significant enough to outweigh potential gains from such activities will be a strong deterrent. Encouraging and protecting internal whistleblowers through attractive incentive mechanisms and robust protection can also help uncover malpractices early.
Tech monitor: AI and ML have enhanced regulators’ ability to monitor trading patterns and detect anomalies. These tools can also identify more subtle and sophisticated forms of front-running, such as trading in highly correlated securities that traditional surveillance systems might miss.
Look within AMCs’ surveillance systems and internal control mechanisms should be regularly updated to adapt to evolving market practices.
Eye in the sky: Setting up an independent oversight committee or hiring an external consultant to review order-routing practices and compliance with best execution principles could help.
Bond with the best AMCs can benchmark their execution quality against any industry standard or peer group, allowing them some room to identify areas for improvement in addition to having optimal execution outcomes, as is the case with the US SEC regarding best execution requirements. MiFID II, which provides a legal framework for securities markets and investment intermediaries, in addition to trading venues in the EU, requires investment firms to report on the quality of their order execution to clients upon request.
Automation: Automated order-routing systems could also be employed, setting a robust price target given the market volatility, liquidity and impact.
Educate investors: Continuous education of investors about the risks and signs of unethical behaviour is essential.
Above all, MF industry stakeholders must remain vigilant and proactive in identifying and addressing these challenges to ensure that the sector remains reliable and integral to the financial market landscape.