In a rare instance of asking the mutual fund industry to self-regulate, the Securities Exchange Board of India (SEBI) had asked Association of Mutual Funds of India (AMFI) to formulate an institutional mechanism for fund houses to police their employees for market abuse. AMFI has now come up with a three-tier mechanism through which Asset Management Companies (AMCs) can detect and prevent fraudulent practices such as front-running, insider trading and leakage of price sensitive information.

Under this, AMCs will be required to monitor the impact of trades on prices and trading volumes of stocks and track these metrics in the run-up to their trades. They will need to regularly scan recorded communication and CCTV footage. Trading disclosures from key employees, their immediate relatives and empanelled brokers will also be reviewed for suspicious patterns. Any red-flagged transactions from these exercises are to be shared with the regulator. This mechanism will operate in addition to SEBI’s existing regulations on market abuse. SEBI has had elaborate regulations in place to prevent front-running, insider trading and other forms of fraud by mutual fund employees for a few years now. These rules restrict access to dealing rooms, require CCTV monitoring of investment activity and ban all communication devices in the dealing room, while requiring mandatory recordings of phone conversations by fund managers and dealers during trading hours. Key personnel of mutual funds are required to declare all personal trades to the compliance officer. But despite all this, cases of front-running and insider trading in mutual funds have kept cropping up, including one just last year where a dealer in Axis Mutual Fund was found to have used a large network of broking contacts to front-run the fund’s trades for an extended period. In fact, most cases of front-running taken up by SEBI so far, have been brought to its attention by external whistleblowers.

The new AMFI-directed institutional mechanism puts the onus on AMCs as the first line of defence in preventing, detecting and reporting fraud. Now, top managers cannot simply pin the blame on rogue employees and carry on with business-as-usual. When alerted to instances of fraud, SEBI tries to compile corroborative evidence in the form of suspicious trading patterns. But this provides only circumstantial evidence, making it tough for SEBI to make its charges stick. Relying on whistleblower alerts can also make the money trail go cold. With the new mechanism in place, individual AMCs can devote more time and resources to detailed evaluation of their own trade data and CCTV footage than SEBI which is tasked with overseeing 44 AMCs.

But to really prevent market abuse, SEBI will also need to take more effective enforcement actions against the guilty. Soft-ball measures such as banning them from the market for a few years, levying a nominal fine or entering into settlement with them without proving guilt, do not offer sufficient deterrence.

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