Corruption and Fraud in Financial Markets
Malpractice, Misconduct and Manipulation

Identifying malpractice and misconduct should be top priority for financial risk managers today

Corruption and Fraud in Financial Markets identifies potential issues surrounding all types of fraud, misconduct, price/volume manipulation and other forms of malpractice. Chapters cover detection, prevention and regulation of corruption and fraud within different financial markets. Written by experts at the forefront of finance and risk management, this book details the many practices that bring potentially devastating consequences, including insider trading, bribery, false disclosure, frontrunning, options backdating, and improper execution or broker-agency relationships.

Informed but corrupt traders manipulate prices in dark pools run by investment banks, using anonymous deals to move prices in their own favour, extracting value from ordinary investors time and time again. Strategies such as wash, ladder and spoofing trades are rife, even on regulated exchanges ? and in unregulated cryptocurrency exchanges one can even see these manipulative quotes happening real-time in the limit order book. More generally, financial market misconduct and fraud affects about 15 percent of publicly listed companies each year and the resulting fines can devastate an organisation's budget and initiate a tailspin from which it may never recover.

This book gives you a deeper understanding of all these issues to help prevent you and your company from falling victim to unethical practices.

• Learn about the different types of corruption and fraud and where they may be hiding in your organisation
• Identify improper relationships and conflicts of interest before they become a problem
• Understand the regulations surrounding market misconduct, and how they affect your firm
• Prevent budget-breaking fines and other potentially catastrophic consequences

Since the LIBOR scandal, many major banks have been fined billions of dollars for manipulation of prices, exchange rates and interest rates. Headline cases aside, misconduct and fraud is uncomfortably prevalent in a large number of financial firms; it can exist in a wide variety of forms, with practices in multiple departments, making self-governance complex. Corruption and Fraud in Financial Markets is a comprehensive guide to identifying and stopping potential problems before they reach the level of finable misconduct.

About the Editors xv

List of Contributors xvii

Foreword xix

Acknowledgements xxi

Chapter 1: Introduction 1
Carol Alexander and Douglas Cumming

Part I What are Manipulation and Fraud and Why Do They Matter? 11

Chapter 2: An Overview of Market Manipulation 13
Tālis J. Putniņš

2.1 Introduction 14

2.2 Definitions of Market Manipulation 16

2.2.1 Legal Interpretation and Provisions against Market Manipulation 16

2.2.2 Economics and Legal Studies Perspective 18

2.3 A Taxonomy of the Types of Market Manipulation 19

2.3.1 Categories of Market Manipulation 19

2.3.2 Market Manipulation Techniques 22

2.4 Research on Market Manipulation 26

2.4.1 Theoretical Literature 27

2.4.2 Empirical Literature 30

2.4.3 Conclusions from the Research on Market Manipulation 35

2.5 Summary and Conclusions 39

References 40

Chapter 3: A Taxonomy of Financial Market Misconduct 45
Ai Deng and Priyank Gandhi

3.1 Introduction 46

3.2 Challenges in Research on Financial Market Misconduct 50

3.3 Defining Financial Market Misconduct 51

3.3.1 Price Manipulation 53

3.3.2 Circular Trading 54

3.3.3 Collusion and Information Sharing 55

3.3.4 Inside Information 56

3.3.5 Reference Price Influence 56

3.3.6 Improper Order Handling 57

3.3.7 Misleading Customers 58

3.4 Defining Financial Fraud 59

3.4.1 Credit Card Fraud 59

3.4.2 Money Laundering 60

3.4.3 Financial Statement Fraud 60

3.4.4 Computer Intrusion Fraud 61

3.5 Conclusion 61

References 61

Chapter 4: Financial Misconduct and Market-Based Penalties 65
Chelsea Liu and Alfred Yawson

4.1 Introduction 66

4.2 Notable Cases of Financial Reporting Fraud 69

4.3 Financial Reporting Misconduct and Legal Redress 70

4.4 Evolution of US Financial Regulations 71

4.4.1 Private Securities Litigation Reform Act (1995) 72

4.4.2 Sarbanes–Oxley Act (2002) 72

4.4.3 Dodd–Frank Act (2010) 73

4.5 Legal versus Market-Based Penalties for Financial Misconduct 74

4.5.1 Common Forms of Legal Penalties 74

4.5.2 Role of Market-Based Penalties 75

4.6 Firm-Level Penalties for Corporate Financial Misconduct 75

4.6.1 Direct Economic Costs Captured in Loss of Market Value 83

4.6.2 Loss of Firm Reputation 83

4.6.3 Spillover of Reputational Effect 84

4.6.4 Governance Risk and Insurance Premiums 85

4.6.5 Reduced Liquidity 85

4.6.6 Access to Financing 85

4.6.7 Reduced Innovation 86

4.6.8 Mergers and Acquisitions 86

4.7 Individual-Level Penalties for Corporate Financial Misconduct 87

4.7.1 Executive and Director Turnover 87

4.7.2 Impaired Career Progression 95

4.7.3 Loss of Reputation 96

4.7.4 Executive Compensation 97

4.7.5 Strengthened Monitoring 97

4.8 Causes, Risks, and Moderators of Financial Misconduct 98

4.8.1 Fraud Incentives 98

4.8.2 Risk Factors 113

4.8.3 Public Enforcement: Regulatory and Judicial Stringency 115

4.8.4 Public Enforcement: Detection and Surveillance 116

4.8.5 Private Enforcement 117

4.9 Other Non-Financial Misconduct 118

4.10 Concluding Remarks 119

References 120

Chapter 5: Insider Trading and Market Manipulation 135
Jonathan A. Batten, Igor Lončarski, and Peter G. Szilagyi

5.1 Introduction 135

5.2 Regulatory Framework on Insider Trading and Market Manipulation 140

5.3 Recent Examples of Market Manipulation and Insider Trading 145

5.4 Conclusions 148

References 149

Chapter 6: Financial Fraud and Reputational Capital 153
Jonathan M. Karpoff

6.1 Financial Frauds in the 2000s 154

6.2 The Effects of Fraud Revelation on Firm Value and Reputational Capital 156

6.2.1 Market Value Losses When Financial Misconduct is Revealed 156

6.2.2 Spillover Effects 157

6.2.3 Reputational Losses for Financial Misconduct 158

6.2.4 Direct Measures of Lost Reputational Capital 159

6.2.5 Do Misconduct Firms Always Lose Reputational Capital? 160

6.2.6 Rebuilding Reputational Capital 161

6.3 The Effects of Fraud Revelation on Shareholders and Managers 162

6.3.1 Should Shareholders Pay? Do Managers Pay? 162

6.3.2 Do Shareholders Pay Twice? 162

6.3.3 Are Firm-Level Penalties Efficient? 163

6.3.4 Consequences for Managers and Directors 163

6.4 Why Do Managers Do It? Motives and Constraints 165

6.4.1 Motives for Financial Misconduct 165

6.4.2 Constraints on Financial Misconduct 167

6.5 Proxies and Databases Used to Identify Samples of Financial Statement Misconduct 168

6.6 Conclusion: Reputation, Enforcement, and Culture 170

References 171

Part II How and Where Does Misconduct Occur? 179

Chapter 7: Manipulative and Collusive Practices in FX Markets 181
Alexis Stenfors

7.1 Introduction 181

7.2 Different Types of FX Orders 183

7.3 The Unique FX Market Structure 184

7.4 Examples of Manipulative and Collusive Practices in FX Markets 188

7.4.1 Front Running 188

7.4.2 Triggering Stop-Loss Orders 190

7.4.3 ‘Banging the Close’ 192

7.4.4 Collusion and Sharing of Confidential Information 193

7.4.5 Spoofing 195

7.4.6 Market Abuse via Electronic Trading Platforms 196

7.5 The Reform Process 197

References 199

Chapter 8: Fraud and Manipulation within Cryptocurrency Markets 205
David Twomey and Andrew Mann

8.1 Introduction 206

8.2 Why Do fraud and Manipulation Occur in Cryptocurrency Markets? 212

8.2.1 Lack of Consistent Regulation 212

8.2.2 Relative Anonymity 213

8.2.3 Low Barriers to Entry 214

8.2.4 Exchange Standards and Sophistication 214

8.3 Pump and Dumps 215

8.3.1 Case Studies 217

8.4 Inflated Trading Volume 217

8.4.1 Case Study: January 2017 and PBoC Involvement 219

8.5 Exchange DDoS Attacks 220

8.5.1 Case Study 223

8.6 Hacks and Exploitations 224

8.6.1 Exchange Hacks 224

8.6.2 Smart Contract Exploits 229

8.6.3 Protocol Exploitation 230

8.7 Flash Crashes 230

8.7.1 GDAX-ETH/USD Flash Crash 234

8.8 Order Book-Based Manipulations 235

8.8.1 Quote Stuffing 236

8.8.2 Order Spoofing 237

8.9 Stablecoins and Tether 239

8.9.1 Tether Historical Timeline 240

8.9.2 Tether Controversy and Criticism 242

8.9.3 Tether’s Significance in Cryptocurrency Global Markets 245

8.10 Summary and Conclusions 245

References 249

Chapter 9: The Integrity of Closing Prices 251
Ryan J. Davies

9.1 Why Closing Prices Matter 251

9.2 Painting the Tape and Portfolio Pumping 252

9.3 ‘Bang-the-Close’ Manipulation: The Response of Financial Intermediaries 255

9.4 Stock Price Pinning on Option Expiration Dates 259

9.5 Conclusion: Lessons for the Regulation and Design of Financial Markets 263

References 269

Chapter 10: A Trader’s Perspective on Market Abuse Regulations 275
Sam Baker

10.1 Introduction 275

10.2 Getting the Trading Edge 278

10.3 A Typical Trader’s Market Window 281

10.4 Wash Trades 282

10.5 High Ticking/Low Ticking – Momentum Ignition 284

10.6 Spoofing 286

10.7 Layering 290

10.8 Smoking 292

10.9 Case Study: Paul Rotter a.k.a. ‘The Flipper’ 295

10.10 The Innocent and the Guilty 299

10.11 What are Exchanges Doing to Prevent Market Abuse? 301

10.11.1 CME Group 301

10.11.2 ICE 302

10.12 What are Trading Companies Doing to Prevent Abuse? 302

10.13 Will There Be an End to Market Abuse? 303

Part III Who are These Scoundrels? 305

Chapter 11: Misconduct in Banking: Governance and the Board of Directors 307
Duc Duy Nguyen, Jens Hagendorff, and Arman Eshraghi

11.1 Introduction 307

11.2 Literature Review 311

11.3 Research Design 312

11.3.1 Data 312

11.3.2 Empirical Design 313

11.3.3 Variables 314

11.4 Empirical Results 316

11.4.1 Main Results 316

11.4.2 Results for Different Classes of Enforcement Actions 320

11.4.3 Does Better Board Quality Alleviate Shareholder Wealth Losses? 323

11.5 Conclusion 323

References 325

Chapter 12: Misconduct and Fraud by Investment Managers 327
Stephen G. Dimmock, Joseph D. Farizo, and William C. Gerken

12.1 Introduction 327

12.2 Related Research 329

12.3 The Investment Advisers Act of 1940 and Mandatory Disclosures 331

12.4 Data 332

12.4.1 Investment Fraud 332

12.4.2 Form ADV Data and Variables 337

12.5 Predicting Fraud and Misconduct 340

12.5.1 Predicting Fraud by Investment Managers 340

12.5.2 Interpreting the Predictive Content of the Models 345

12.5.3 K-Fold Cross-Validation Tests 346

12.6 Predicting the Initiation vs. the Continuance of Fraud 347

12.7 Firm-Wide Fraud vs. Fraud by a Rogue Employee 349

12.8 Out-of-Sample Prediction and Model Stability 351

12.9 Policy Implications and Conclusions 352

References 355

Chapter 13: Options Backdating and Shareholders 359
Johan Sulaeman and Gennaro Bernile

13.1 Introduction 359

13.2 Stock Return Patterns around Option Grants 360

13.3 The Backdating Practice 361

13.4 Media Coverage, Restatement, and Investigation 362

13.5 Stock Market Reaction to Public Revelations of Backdating 363

13.6 Investor Reaction to (and Anticipation of) Public Revelations 364

13.7 Other Types of Misbehaviour Related to Option Grants 365

13.7.1 Forward Dating 365

13.7.2 Selective Disclosure 366

13.7.3 Option Exercise Backdating 366

13.7.4 Independent Director Backdating 366

13.8 Connections with Questionable Practices by Corporate Executives and Other Agents 366

13.9 Conclusion 367

References 368

Chapter 14: The Strategic Behaviour of Underwriters in Valuing IPOs 371
Stefano Paleari, Andrea Signori, and Silvio Vismara

14.1 Valuing IPOs 371

14.2 The Underwriter’s Incentives in the Valuation of IPOs 373

14.3 Literature Review 374

14.4 Sample, Data, and Methodology 376

14.4.1 Sample and Data 376

14.4.2 Alternative Selection Criteria of Comparable Firms 380

14.4.3 Valuation Bias and IPO Premium 380

14.5 Results 381

14.5.1 Algorithmic Selections 381

14.5.2 Affiliated and Unaffiliated Analysts 386

14.5.3 Underwriters’ Selection of Comparable Firms Pre- vs. Post-IPO 390

14.5.4 Pre- vs. Post-IPO Selections and Industry Effects 394

14.6 Conclusions 396

References 397

Chapter 15: Governance of Financial Services Outsourcing: Managing Misconduct and Third-Party Risks 399
Joseph A. McCahery and F. Alexander de Roode

15.1 Introduction 399

15.2 The Four Components in Outsourcing 402

15.2.1 Efficient Outsourcing 402

15.2.2 The Four-Factor Governance Model 404

15.2.3 Misconduct in Outsourcing and the Ability of Financial Institutions to Monitor 407

15.3 The Interaction between Contracting and Monitoring 408

15.3.1 Characterization of Financial Institutions 409

15.3.2 Risks in Outsourcing Services 412

15.4 Governance Mechanisms to Detect Misconduct in Financial Outsourcing 413

15.4.1 Screening and Detection 414

15.5 Conclusion 416

References 417

Part IV Detection and Surveillance of Financial Misconduct 423

Chapter 16: Identifying Security Market Manipulation 425
Mike Aitken, Ann Leduc, and Shan Ji

16.1 Introduction 425

16.2 Background Legislation 427

16.2.1 Australia 427

16.2.2 UK 428

16.2.3 Hong Kong 428

16.2.4 Canada 429

16.2.5 Singapore 430

16.2.6 Malaysia 430

16.2.7 New Zealand 431

16.3 Attributes of Manipulation 431

16.3.1 How Traders Minimize the Resources Needed for Manipulative Trading 432

16.3.2 Difficulties in Determining Whether Trading Behaviour is Manipulative 433

16.3.3 Surveillance Systems 434

16.4 Detection Algorithms 436

16.5 Conclusion 439

Chapter 17: The Analytics of Financial Market Misconduct 441
Ai Deng and Priyank Gandhi

17.1 Introduction 442

17.2 Financial Economic Analysis 446

17.2.1 Benchmarking to Historical or Past Data 447

17.2.2 Benchmarking to Alternate Proxies 451

17.2.3 Benchmarking to a Model 454

17.3 Quantitative Techniques 456

17.3.1 The Principles of Fraud Detection 457

17.3.2 Popular Supervised Learning Techniques for Fraud Detection 458

17.3.3 Popular Unsupervised Learning Techniques for Fraud Detection 460

17.3.4 Dynamic Misconduct Detection 462

17.4 Conclusion 464

References 466

Chapter 18: Benford’s Law and Its Application to Detecting Financial Fraud and Manipulation 473
Christina Bannier, Corinna Ewelt-Knauer, Johannes Lips, and Peter Winker

18.1 Introduction 474

18.2 Benford’s Law and Generalizations 476

18.2.1 The Basic Principle of Benford’s Law 476

18.2.2 Illustration of Benford’s Law 477

18.2.3 Testing for Conformity with Benford’s Law 478

18.2.4 Considering Further Digits with Benford’s Law 480

18.2.5 When Do Data Conform to Benford’s Law? 482

18.2.6 Limitations of Using Benford’s Law for Identification of Manipulations 483

18.2.7 Generalizations of Benford’s Law for Identification of Manipulations 484

18.3 Usage of Benford’s Law for Detecting Fraud and Deviant Behaviour 485

18.3.1 Forensic Accounting in the Context of Auditing, Internal Control Systems, and Taxation 486

18.3.2 Finance 487

18.3.3 Surveys and Research 490

18.4 A Case Study: Benford’s Law and the LIBOR 491

18.5 Policy Implications 498

18.6 Summary, Limitations, and Outlook 498

References 499

18.A Appendix 504

Part V Regulation and Enforcement 505

Chapter 19: The Enforcement of Financial Market Crimes in Canada and the United Kingdom 507
Anita Indira Anand

19.1 Introduction 507

19.2 Existing Scholarship 508

19.3 Comparative Analysis 512

19.3.1 Canada 512

19.3.2 The United Kingdom 513

19.4 Reform 515

19.4.1 Resource Allocation 515

19.4.2 Principles-Based Regulation 516

19.4.3 Targeted Regulatory Reforms 518

19.5 Conclusion 520

References 520

Chapter 20: A Pyramid or a Labyrinth? Enforcement of Registrant Misconduct Requirements in Canada 527
Mary Condon

20.1 Introduction 527

20.2 Definitional and Institutional Quagmires 529

20.3 The Compliance/Enforcement Continuum 531

20.4 Enforcement Options Available to Sanction Registrant Misconduct 533

20.5 Empirical Information Available about Registrant Misconduct in Canada 535

20.5.1 Criminal Enforcement 535

20.5.2 CSA Non-Criminal Enforcement 536

20.5.3 Director’s Decision Data in Ontario 537

20.5.4 SRO Enforcement 538

20.6 Analysis 538

Chapter 21: Judicial Local Protectionism and Home Court Bias in Corporate Litigation 541
Michael Firth, Oliver M. Rui, and Wenfeng Wu

21.1 Introduction 542

21.2 Institutional Background 544

21.2.1 Decentralization and Local Protectionism 544

21.2.2 Judicial Independence 545

21.2.3 The Heterogeneity of the Legal Environment across Regions 548

21.3 Empirical Evidence 548

21.3.1 Sample 549

21.3.2 Basic Statistics 550

21.3.3 The Wealth Effect for Defendants and Plaintiffs around the Filing Announcements at Different Courts 556

21.3.4 The Impact of Court Location on the Wealth Effect 560

21.3.5 Regression Analysis of the Wealth Effects from a Filing Announcement 560

21.3.6 Heckman Two-Step Analysis of Sample Selection Bias 567

21.3.7 The Impact of Court Location on the Likelihood to Appeal 573

21.3.8 Sensitivity Tests 576

21.4 Conclusion 579

References 580

Index 583

CAROL ALEXANDER, Ph.D., is Professor of Finance at the University of Sussex, Visiting Professor at Peking University PHBS Business School in Oxford and Co-Editor of the Journal of Banking and Finance. She is the former Chair of the Board of the Professional Risk Manager’s International Association and she consults on model design for major exchanges, banks, and fund managers worldwide. She has edited more than a dozen books in finance and risk management and her sole-authored four-volume textbook on Market Risk Analysis (Wiley, 2008) remains the definitive guide to the subject after more than 12 years in print.

DOUGLAS CUMMING J.D., Ph.D., CFA, is the DeSantis Distinguished Professor of Finance and Entrepreneurship at the College of Business, Florida Atlantic University, and Visiting Professor of Finance at Birmingham Business School, University of Birmingham, and Royal Melbourne Institute of Technology. He has published 18 books and over 185 articles in leading journals such as the Academy of Management Journal, Journal of Financial Economics, and Review of Financial Studies, which have been cited over 15,000 times. He is the Managing Editor-in-Chief of the British Journal of Management and Journal of Corporate Finance, and the Founding Editor-in-Chief of the Review of Corporate Finance.