In a recent survey, 53% of the hedge fund managers revealed that they were using alternative data in the quest for alpha. Over 25% of these funds are market leaders, with 8% qualifying as those who follow a quantitative approach.
Access to Premium Data Raises an Ethical and Legal Dilemma
Access to special data has always attracted regulatory attention. More than a decade ago, it was high-frequency trading, where super-fast cables were pulled across global stock exchanges, providing some parties critical data to make trading decisions faster than others. The question then was whether that was fair.
Today, the same question has arisen again. Whether it’s the sales figure of Etsy or the turnover of Apple, many institutional investors no longer need to wait for quarterly reports. They are using smart data, in the form of credit card transactions, mobile phone location data, social media sentiment and even satellite intelligence to estimate future trends. For instance, large amounts of payment data can be accessed by fund managers to determine Amazon’s turnover, although company employees are prohibited from sharing this price-sensitive information.
So, does the use of such alternative data constitute insider trading?
The Big Regulatory Crackdown
Regulatory bodies are debating this issue worldwide. The aim is to make the financial markets a level playing field. The US Securities and Exchange Commission (SEC) for one has been investigating such activities for years. The Commission today uses advanced surveillance techniques, with the help of the Division of Economic and Risk Analysis (DERA), the Analysis and Detection Center of the Division of Enforcement’s Market Abuse Unit, and other technology partners.
In mid-September 2021, the US SEC issued its first-ever enforcement action regarding the use of alternative data. The Commission charged App Annie Inc., with violations of Section 10(b) of the Exchange Act and Rule 10b-5, for enabling insider trading violations. The company is a prominent alternative data provider and has agreed to settle the securities fraud charges by paying over $10 million.
In March 2020, the UK Financial Conduct Authority (FCA) issued the Call for Input (CFI) paper, to look into the use of advanced analytics in the wholesale financial markets. The FCA’s concern was that while data is critical to making investment decisions and meeting regulatory obligations, the rise of data aggregators is limiting equitable availability of data to all participants.
In January 2021, in response to the CFI, the Alternative Investment Management Association (AIMA) and Managed Funds Association (MFA) cited various advantages of allowing access to alternative data for hedge funds. Prominent among them was the data’s role in expanding market liquidity, promoting competition, informing investment decisions, compliance, and better risk management practices.
Implications for Private Fund Managers and Data Providers
According to Arnoud Pijls, assistant professor of Corporate Law & Capital Markets at the Erasmus School of Law, not all data sets can constitute the risks of insider trading. For instance, the use of data from Twitter or job boards, to determine whether a listed company is about to increase its hiring program or plans to expand, can be seen as public sources of data. Using this kind of data doesn’t make a company guilty of market abuse.
Moreover, he stresses that increased regulation can completely hinder innovations in the field, as these types of data sets ensure market transparency and efficiency.
However, the recent decision of the US SEC has clear implications for private fund managers, data providers, and traders of listed assets.
In its 2020 investigation priorities, the SEC’s Office of Compliance Inspections and Examinations (OCIE) focused on two areas:
- Whether an investment manager gets material, non-public information (MNPI) from an alternative data vendor.
- Whether the manager has properly enforced policies and procedures to address the risks of alternative data use.
So, to remain compliant, fund managers will need to see whether their policies and controls are addressing concerns such as:
- Due diligence of alternative data providers, at onboarding as well as on an ongoing basis.
- Establishing controls around web scraping done by vendors and employees.
- Ensuring sufficient consent acquired by the vendor from the underlying source of data. Here, there should be supporting documentation, such as redacted copies of disclosures made to the data sources. There has to be an assurance that data was not obtained in “breach of duty.”
- Establishing roles and responsibilities of employees involved in the review and use of alternative data.
It is simply not enough anymore for alternative data providers to say that consumer transaction data has been “anonymised.” They need to reassure their clients that personally identifiable information (PII) has not been sourced illegally. Moreover, the legal landscape related to web crawling is always changing. Compliance personnel will have to collaborate with investment and technology experts to evaluate the source of data and methods used in data collection.
Maintaining Compliance in the UK and EU
In the UK and the broader European Union, 2 key aspects define the crime of insider trading: materiality and public vs. non-public. In the UK, unlike the US, there is no aspect related to “breach of duty.” So, it all comes down to one question – was the data used publicly available?
However, in the UK, “public” means widespread availability, rather than the US definition of “widespread dissemination.” So, if a company can buy the dataset, it means that the information is public. Hence, datasets that are allowed in the US might also be allowed for use in the UK and vice versa.
Some experts argue that important information is already processed at the stock price. This means that there is no risk of information asymmetry between companies and investors.
But, recent regulatory crackdowns impart important lessons for advisers. Now, they not only need to maintain written policies and protocols, but also need to invest in the ongoing implementation of proper policies. Documentation is also important, considering the ever-changing regulatory landscape.