Thursday, May 24

Buyside should be wary of alternative data as insider trading, says report

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The alternative data industry need to take steps to “inoculate” from adverse media and regulatory scrutiny, according to a recent report by Integrity Research Associates.

The systematic use of alternative data is relatively new and only beginning to attract critical scrutiny, and the research firm calls for “developing consistent and broadly adopted compliance standards” in order to reduce legal risk and compliance costs.

Regulatory authorities cited in the report include the US’ Securities and Exchange Commission and Consumer Financial Protection Bureau, and the UK’s Financial Conduct Authority and Information Commissioner’s Office, among others.

How alternative data can be defined as insider trading is one of the major issues examined in the report.

The research firm defines alternative data as “the intersection of big data and investment research”: when applied to investment research, alternative data is the collection, cleansing, packaging, modeling, and distribution of large unstructured and structured data sources to generate predictive insights and improved investment returns.

In the US, when alternative data is potentially both material and non-public, protection against insider trading rests on whether the data was obtained in violation of a fiduciary duty.

This may require consent to collect the information as well as consent that it be distributed to a third party. With the growing proliferation of data, the likelihood of inadequate consents increases, thereby raising the risk of violations of fiduciary duty, according to the report.

A case was cited in which US financial watchdog, the SEC, has already successfully prosecuted an insider trading case involving alternative data, in which two data analysts obtained material non-public information by analyzing credit card transactions.

Because they obtained access without the consent of the owner of the data, they were prosecuted for insider trading and forced to pay over $18 million in disgorgement and penalties.

EU regulation, the report noted, is substantially different, and because of those differences lawyers say it is harder to buy alternative data in the UK and Europe, while some say exclusive data sets are effectively banned.

Another major legal risk highlighted in the report is that alternative data may be in violation of consumer protection regulation. There are a few concerns for asset managers relating to Personally Identifiable Information (PII) depending on how it is obtained, whether PII-level information is included in the data obtained by asset managers, and how PII data is anonymized.

In addition, web crawling is becoming broadly used as a source of alternative data and an investment
research tool by both the sell side and by asset managers including hedge funds.

However, firms utilizing web crawling or harvesting, need to manage the associated compliance risks due to an ever-growing body of regulatory deliberation associated with the practice.

The courts find that operating a web-crawler is a legal and expected activity on the internet, however, financial firms need to minimize the associated potential headline risk as well as the potential legal costs.

The report also cited risks for the firm using the data internally that standards could solve: data quality risk; immateriality (alternative data may be scarce or hard to obtain but that does not necessarily mean it will contribute positively to the investment process); and model risk.

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