Case Study: Investor Protection and Compliance Risks in Investment Activities

Case Study: Investor Protection and Compliance Risks in Investment Activities

After completing this reading, you should be able to:

  • Summarize important regulations designed to protect investors in financial instruments, including MiFiD, MiFiD II, and Dodd-Frank.
  • Describe and provide lessons learned from the case studies involving violations of investor protection or compliance regulations.

Important Regulations Designed to Protect Investors

The phrase “investor protection” here refers to laws and rules designed to make sure that investors are well-informed about their investments before engaging in financial transactions.

Both the EU and the US have regulations and laws pertaining to investor protection. Violations of investor rights have made some banks and investment firms pay mind-boggling fines and penalties. Clients, Products, and Business Practices (CBPB), the fourth event category of the Basel taxonomy for operational risk, is typically where compliance with financial rules and regulations lies. Compliance with investor protection laws typically falls under subcategory 4.2: “Improper Business or Market Practices” or 4.1: “Suitability, Disclosure & Fiduciary.”

Mechanisms for investor protection:

  • Aid in preventing misrepresentation by institutions and intermediaries.
  • Establishing responsibility in cases of fraud or insider trading.
  • Facilitate cross-jurisdictional regulatory and law enforcement cooperation.


The Markets in Financial Instruments Directive (MIFID) is a 2004 EU directive that has been in effect throughout the EU since November 2007. It aims to provide investors in financial instruments with a high level of protection.

MIFID specifies organizational and business practices for investment firms as well as authorization requirements for regulated markets. In order to prevent market abuse, it establishes the requirements for regulatory reporting and transaction transparency. In addition, it stipulates guidelines for the admission of financial instruments for public trading.

Evolution into MIFID II

The European Commission updated the MIFID framework in 2014, creating “MIFID II” and “MIFIR” (Markets in Financial Instruments Regulation). MIFID II added new requirements for the public disclosure of trading activity data as well as for the disclosure of transaction data to supervisors and regulators. The MIFIR regulation addresses the incentive systems as well as other facets of financial corporations’ investing activities, such as:

  • Pay for traders, advisors, and potential conflicts of interest.
  • Fair and non-misleading communication with customers.
  • Investment advisory definition and objectivity.
  • Sales procedure and product management.
  • Best deal execution for the clients.
  • Transactions with qualified counterparties.


The Dodd-Frank Wall Street Reform and Consumer Protection Act in the United States was implemented as a regulatory response to the 2007 financial crisis in an effort to avert its recurrence. The Investor Protection Act provided the following investor protections:

  • Enhanced protections for whistleblowers under the act.
  • Formed a committee to engage with the Securities and Exchange Commission (SEC) regarding regulatory priorities surrounding new financial products, fee structures, and trading methods.
  • Required firms that buy and sell derivatives to do so through clearinghouses.
  • Restructured the financial regulation and established a council to oversee financial stability.
  • Established the Volcker Rule that sought to stop commercial banks from profit-driven speculation and proprietary trading.
  • Established the Consumer Financial Protection Bureau (CFPB) as an independent financial regulator to regulate consumer finance markets.

Compliance Risk Management in Investment Activities

A purposeful violation of compliance in financial market operations is an instance of internal fraud. Unintentional compliance breaches are frequently brought on by poor policies or human error. Many of the measures taken to stop internal fraud also work to prevent errors. The intention of the perpetrator is what distinguishes a fraud from an error.

The same factors that contribute to internal fraud also contribute to market abuse risk. These include:

  • Low levels of employee involvement within the company.
  • Stress or employee dissatisfaction.
  • Inadequate resource allocation to corporate units or activities.
  • Weak culture of ethics.

Factors that contribute to compliance risk in market activity include:

  • The asymmetry in information between buyers and sellers. Compared to banks and asset management firms, retail investors typically have significantly less knowledge.
  • Traders’ conflicts of interest when they trade for the company and for their clients’ books.
  • Economic factors like spikes in market volatility boost the volume of transactions, which increases the incidence of errors.

Effective measures for ensuring that investment activities are carried out properly include:

  • The oversight and supervision of workers and trades.
  • Robust back-office and middle-office operations.
  • Sufficient rules and regulations.
  • Employee education.
  • A culture of ethics that is robust and is maintained by regular onboarding and training.

Lessons Learned from the Case Studies Involving Violations of Investor Protection or Compliance Regulations

Statistics and Record Fines Cases for Investor Protection Violations

According to US fine statistics for investor protection violations, 6,612 penalty records totaling close to $82 billion in fines and penalties were recorded between 2000 and 2022.

As part of the settlement of a lawsuit in which UBS was accused of “misrepresenting auction rate securities to investors as safe, cash-equivalent products when in reality they faced increasing liquidity risk,” the harshest individual penalty was imposed on UBS. The firm was directed to buy back $ 11 billion in securities and pay penalties totaling $150 million.

JP Morgan currently holds the record for paying the biggest fine for spoofing. In this context, spoofing is the practice of quickly submitting and canceling orders to create the appearance of market demand and so manipulating prices in one’s benefit. JP Morgan was fined $920 million by the CFTC.

These case studies demonstrate how perceptions and laws have evolved over time. Prior to the creation of investor protection laws, techniques such as spoofing were considered commonplace.

FINRA Fines Deutsche Bank Securities, Inc. $ 2 Million for Best Execution Violations

The Financial Industry Regulatory Authority (FINRA), a US-based regulatory agency organization, is under the SEC’s supervision and controls brokerage firms. It is committed to maintaining market integrity and protecting investors.

The duty for businesses to look for the most advantageous terms reasonably available for a customer’s orders is FINRA Rule 5310. Between 2014 and 2018, FINRA discovered an anomaly in Deutsche Bank Securities’ transactions. The bank was delaying the execution of customers’ market orders and lowering fill rates by routing customer orders to exchanges through its smart order router before routing any part of the order to an exchange unless customers opted out of this routing preference. This was known as the “SuperX ping.” According to the firm’s filings, it’s possible that this behavior led to trade rebates being obtained by the company.

Furthermore, Deutsche Bank Securities failed to disclose this to the markets to which it routed orders. Though it neither disputed nor accepted FINRA’s allegations, Deutsche Bank Securities eventually agreed to pay the penalty.

Regulators typically impose harsh fines in cases of a breach where businesses continue non-compliant practices for profit, offsetting any benefits accrued. The penalties are intended to serve as a deterrence against additional deviations and to encourage other organizations to modify their procedures and monitoring practices in order to assure compliance.

Practice Question

Considering the core principles of investor protection outlined in MiFID, MiFID II, and the Dodd-Frank Act, which of the following actions by MetroGlobal Bank would MOST LIKELY be flagged as a potential violation of these principles?

A. Launching a new financial instrument without regulatory reporting and lacking transaction transparency.

B. Implementing a pay structure for traders that is based solely on the bank’s overall profitability.

C. Offering a straightforward fixed deposit product to retail clients.

D. Focusing on promoting only those products that have the highest profit margin for the bank to qualified counterparties.


The correct answer is A.

Both MiFID and MiFID II stress the importance of transparency and regulatory reporting. MiFID specifies organizational and business practices and sets guidelines for the admission of financial instruments for public trading with an emphasis on preventing market abuse. MiFID II added new requirements for the public disclosure of trading activity data and for the disclosure of transaction data to supervisors and regulators. The Dodd-Frank Act also emphasizes transparency, especially in the context of derivatives trading. Hence, not ensuring transaction transparency or failing in regulatory reporting for a new financial instrument would likely be in violation of these regulations.

B is incorrect: While pay structures and potential conflicts of interest are a concern, especially as outlined in MIFIR regarding traders and advisors, the choice doesn’t specifically state any direct misalignment with investor interests or any inherent violation. The pay structure, on its own, based on the bank’s profitability, does not indicate a lack of transparency or a direct violation of the mentioned regulations.

C is incorrect: Offering a straightforward fixed deposit product to retail clients doesn’t seem to violate the core principles of the mentioned regulations. Fixed deposits are typically transparent, easy-to-understand products that wouldn’t typically fall under the more complex regulatory requirements designed to protect investors from misrepresentation or lack of information.

D is incorrect: While promoting products with higher profit margins might raise concerns about best execution duties, especially under MiFID II’s focus on the best deal execution for clients, the choice specifically mentions “qualified counterparties.” Transactions with qualified counterparties are often treated differently under regulations, given the assumed sophistication and information availability for such counterparties.

Things to Remember

  • Investor protection ensures fairness and transparency in financial markets, preventing deceitful or manipulative practices.
  • It involves regulations and guidelines to make sure investors have access to accurate information before making investment decisions.
  • It seeks to mitigate conflicts of interest among financial institutions, advisors, and their clients.
  • At its core, investor protection focuses on maintaining trust and confidence in the financial system, promoting stability and growth.
  • Effective investor protection creates a level playing field, ensuring that all investors, regardless of size or sophistication, are treated fairly.
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