Capital markets play a critical role in a country’s economic development, providing avenues for raising capital and promoting investment. Kenya’s capital market is regulated by the Capital Markets Authority (CMA), which ensures transparency, fairness, and efficiency. However, like many financial systems, Kenya’s capital markets are susceptible to irregular trading activities that, if left unchecked, can destabilise investor confidence and harm the integrity of the financial system.

The recent request by the Central Bank of Kenya (CBK) for the CMA to investigate irregular trading activities involving the National Social Security Fund (NSSF) brings to light the importance of understanding and mitigating such activities.

What constitutes irregular trading under the Capital Markets Act?

The Capital Markets Act, Chapter 485A of the Laws of Kenya, provides the legal framework for regulating capital markets. Irregular trading activities are simply defined as actions that violate the principles of transparency, fairness, and efficiency in market operations.

Under the Capital Markets Act, several forms of misconduct could be classified as irregular trading, including: –

1. Market manipulation: Market manipulation involves deliberately inflating or deflating the price of securities to create a false or misleading appearance of active trading. In the case of NSSF, the CBK flagged transactions where bonds were bought at significantly higher prices than the market average and sold at lower prices shortly after. Such transactions could be construed as efforts to distort market prices, which harms the price discovery process. Market manipulation is prohibited under the Capital Markets Act because it erodes investor trust and undermines the credibility of the financial markets.
2. Insider trading: This occurs when individuals with access to non-public, material information trade securities based on that information. Though CBK’s letter does not specifically mention insider trading, any unusual price movements may raise suspicions of insider knowledge influencing the trades. The CMA considers insider trading a severe violation because it gives certain parties unfair advantages over regular investors, thus compromising the fairness of the market.
3. Wash trading and circular trading: Wash trading refers to the practice where an investor simultaneously buys and sells securities to create artificial volumes without intending to actually transfer ownership of the asset. Circular trading involves a group of traders buying and selling a security among themselves to inflate its price.

The pattern of the NSSF selling bonds at lower prices only to repurchase them at higher prices shortly afterwards might suggest elements of wash or circular trading. These practices artificially boost transaction volumes and mislead other investors into thinking there is significant market interest in the securities.

4.                 Front-running: Front-running is the unethical practice of a broker or investment manager trading stocks or bonds based on the advanced knowledge of pending orders from a client. This is done to profit from price changes that are likely to occur once the client’s large order is executed.

In such a scenario where the NSSF, one of Kenya’s largest institutional investors, allegedly engaged in suspicious trades, it raises the question of whether front-running may have occurred, especially given the significant volumes of securities involved.

Legal framework and penalties for irregular trading

The Capital Markets Act provides mechanisms for dealing with irregular trading, ranging from investigations and enforcement actions by the CMA to imposing sanctions on individuals and entities found culpable.

Legal consequences for irregular trading could include fines and penalties for the entities found culpable, criminal prosecution of the individuals involved, suspension and revocation of the listed company’s licences, and compulsion to compensate investors for losses incurred.

Mitigating risks: How entities can steer clear of irregular trading

Ensuring compliance with the Capital Markets Act and maintaining a robust risk management framework is essential for all players in the financial markets. For entities like the NSSF and other institutional investors, several measures can be adopted to avoid engaging in irregular trading activities:

• Enhanced governance structures: One of the first steps to mitigating irregular trading is having a robust internal governance structure. Boards and management teams must ensure proper oversight of trading activities. Establishing risk and compliance committees to regularly review trades and transactions can help detect and prevent irregularities before they escalate.
• Implementing strong compliance programmes: A sound compliance program that includes regular staff training on the requirements of the Capital Markets Act is crucial. Employees need to be aware of what constitutes irregular trading, including insider trading and market manipulation, to avoid inadvertently engaging in these activities. Compliance programs should also include strict reporting and whistleblowing mechanisms to allow employees to report any suspicious activities.
• Utilising advanced monitoring tools: Entities can leverage technology to monitor their trading activities in real-time. Advanced algorithms and AI-based tools can identify unusual patterns, such as the sudden purchase of bonds at abnormally high prices or unusually timed sales. Automated alerts can be set to notify compliance officers of trades that fall outside of established norms, allowing for prompt investigation.
• Strengthening market surveillance and coordination with regulators: Regular communication with regulators like the CMA and the CBK can help entities stay ahead of regulatory expectations. Collaborative efforts, such as providing timely information on trading activities and working with the regulator to resolve any issues, can help maintain a good reputation and prevent violations.
• Ensuring ethical culture and leadership accountability: Ethical leadership and a culture of compliance are essential in promoting lawful behaviour. Executives and board members must lead by example, ensuring that ethical considerations are prioritised in all business operations. Leadership accountability can reduce the risk of decisions that may lead to irregular trading, especially in high-stakes financial environments.

Conclusion

Irregular trading activities, whether intentional or due to oversight, can have serious legal, financial, and reputational consequences for entities operating within Kenya’s capital markets.

The consequences of irregular trading activities extend beyond the immediate legal penalties imposed by regulators. The reputational damage associated with being involved in questionable trading practices can have long-lasting effects. Not only would investors, both institutional and retail, potentially lose confidence in a company, leading to divestment and difficulty raising capital in the future, but also the increased public scrutiny and negative publicity and the attendant loss of public trust could be extensively damaging.

Adhering to the Capital Markets Act and implementing robust governance, compliance, and monitoring frameworks are essential steps for mitigating the risks associated with such activities. For entities, safeguarding against irregular trading not only protects them from legal penalties but also preserves the integrity and trust of Kenya’s financial markets.