Sealing information leaks

Once upon a time, there were investment banks, retail banks, stockbrokers and various other specialized financial service providers, and they all did their different things. But that’s old fashioned: now, many financial institutions want to do everything, and regulations have been adapted accordingly.

But that has led to a problem: if a financial institution is a major investor in a company, perhaps with seats on the board, it may be privy to information which could influence its decision regarding whether to lend money to that company – or its competitors. It will also gain knowledge that it can use when advising its other clients whether to buy shares in the company – and it will have its own interest in whether those shares get bought. It may be able to deal in shares, either on its own behalf or on behalf of others, on the basis of inside information it has gained as an investor.  

Such conflicts of interest have led in the past to serious scandals: for example, banks have bought shares in one company while advising another company about its acquisition, thus manipulating the price to its benefit. Or research divisions have been overoptimistic about the prospects of companies in which the financial institution has an interest.

Chinese Walls
It was securities firms themselves, which introduced the idea of Chinese Walls, as a way of restoring credibility to their damaged reputation. A Chinese Wall separates the various functions of a financial institution so that they do not communicate.   

That has increased the relevance of technology to prevent members of staff from moving from one area to another, either physically or virtually. Recently, ASSA ABLOY has been cooperating with Cisco Systems to develop a system, which they have presented jointly. It ensures that only authorized staff, who have badged in to a specific physical space, would be able to access specific IT areas. 

“The door is seen as part of the IT infrastructure,” says Eric Michélsen, director of interconnectivity at ASSA ABLOY. “In this solution, both the access and the log-in are handled by one authorization server.”  The system checks whether the card holder is really the authorized person by using different methods of identification – for example, a card combined with a PIN-code for access and a password together with a fingerprint scan for log-in. 

Conflicts of interest
As a good example of Chinese Wall policy, the Netherlands-based bank ING publishes the following statement: “ING has established policies, procedures and physical arrangements (collectively ‘Chinese Walls’) designed to manage confidential information and prevent the inadvertent spread and misuse of inside information, or the appearance thereof. . . Chinese Walls are designed to operate as barriers to the passing of Inside Information and Confidential Information. Chinese Walls are also designed as a means of managing Conflicts of Interest.”  

Spokesperson Carolien van der Giessen explains, “Within ING Investment Management itself, the department managing the proprietary assets of ING is on a different floor (with controlled access) than the fund managers who manage third-party assets.” 

Van der Giessen says that, in cases where a conflict of interest could occur, “We may take additional steps such as disclosing the potential conflict of interest to clients, declining to act (for example, by abstaining from exercising voting rights) or declining a mandate.”

People will talk
Openness is a major issue, says Nejat Seyhun, professor of finance at the University of Michigan School of Business. His study, “Insider Trading and Effectiveness of Chinese Walls in Securities Firms”, to be published in the Journal of Law, Economics and Policy, argues that Chinese Walls are often porous, and securities firms which have representation on the boards of companies often use the information they gain for investment purposes. “I don’t think clients know what’s being done with their information,” he tells The Future Lab. Clients “should assume that Chinese Walls are porous,” and should demand to know, for example, about any trades in their shares, or how their shares move every second around the time that their orders are being executed.  

Professor Seyhun says that he doesn’t have much faith in technical fixes. “As long as there are financial incentives to use insider information, people will do so.” After all, you can’t stop people talking. But technology does have something to offer: “You can tell who has had access when something does happen. You can put them on a don’t-trade list. And if there’s a breach, you can tell the client.” 

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