Chapter 1
Introduction

Carol Alexander

University of Sussex

Douglas Cumming

Florida Atlantic University

This book covers two general areas of financial market misconduct:

1. Market manipulation in the course of financial trading on stock exchanges (hereafter referred to as "market manipulation" in this chapter), and
2. Financial fraud, or non-trading related fraud (hereafter referred to as "financial fraud" in this chapter).

The CFA Institute (2014) survey of its members shows that most practitioners believe that market manipulation and financial fraud are among the most important issues facing financial markets around the world. Indeed, market manipulation and both types of financial fraud are commonplace. For instance, Cumming, Dannhauser and Johan (2015) report that roughly 1.9%, 4.5%, and 5.1% of NYSE, NASDAQ, and pink sheet companies, respectively, face enforcement actions from the Securities and Exchange Commission (SEC) each year. Similarly, detected fraud cases affect approximately 3.8% of listed companies in China each year. But detected fraud is just the tip of the iceberg, so to speak, and Dyck, Morse and Zingales (2010, 2014) estimated that up to 14% of all US firms have engaged in fraud.

Enforcement varies significantly across countries. In fact, there are enormous differences in enforcement rates in Europe, despite countries having similar market misconduct rules (Cumming, Groh, and Johan, 2018). And there is scant enforcement in some emerging markets such as Brazil, which had its first ever reported insider trading case in 2011. Even in Germany, the (now defunct) Neur Markt, a small-company growth market, reported only four cases of fraud (Cumming et al., 2015).

The consequences of fraud are extremely severe to managers and shareholders alike. Karpoff et al. (2008a) shows that fraud costs firms 20-38% of a firm's long-term stock market value. Karpoff et al. (2008b) show significant negative career consequences to managers that engage in market manipulation and financial fraud: 93% lose their jobs, and 28% face criminal prosecution, serving an average of 4.3 years of jail time.

This book offers a unifying look at the different types of market manipulation and financial fraud. The chapters in this book:

• Explain the various types of market manipulation and financial fraud;
• Describe the factors that mitigate or exacerbate their occurrence;
• Discuss their consequences in terms of penalties and/or financial market impact;
• Provide evidence for the presence of fraud in specific markets, such as cryptocurrencies, LIBOR and foreign exchange;
• Summarize the lessons to be learned about detection and enforcement of market manipulation and financial fraud.

The book is organized into five sections. Part I provides a general overview, where different types of market misconduct and financial fraud are defined, and the market and reputational penalties are explained. Part I comprises 5 chapters (Chapters 2-6) from leading authors around the world. The scope of the chapters is explained in Table 1.1, Panels A (for market manipulation) and B (for financial fraud). Chapter 2 by Talis J. Putnins provides a comprehensive overview of the different types of market manipulation. Chapter 3 by Ai Deng and Priyank Ghandi includes additional information on market manipulation and extends the discussion to financial fraud. Chapter 4 by Chelsea Liu and Alfred Yawson offers a comprehensive review of the market and reputational penalties associated with market manipulation and financial fraud. Chapter 5 by Jonathan Batten, Igor Loncarski and Peter Szilagyi provides detailed explanations of various issues in price manipulation and insider trading and describes detected cases of such misconduct. Chapter 6 by Jonathan Karpoff offers critical insights into the consequences of financial fraud based on findings from precisely compiled large-sample evidence.

Part II provides analyses of specific contexts and markets. Chapter 7 by Alexis Stenfors provides insights into the foreign exchange market based on his first-hand practical experience as well as his research on topic. Chapter 8 by David Twomey and Andrew Mann examines the cryptocurrency market. Chapter 9 by Ryan Davies offers a detailed look at the context of closing prices, which are frequently the subject of manipulation, since closing prices are used in determining various other things in financial market, such as executive compensation, whether options trade in or out of the money, and M&A prices and terms. Chapter 10 by Sam Baker provides insights into market manipulation and financial fraud cases from the experience and perspective of a financial market trader who has dealing with regulations on a daily basis for many years.

Part III considers different financial market players that engage in market manipulation and financial fraud. Chapter 11 by Duc Duy Nguyen, Jens Hagendorff and Arman Eshraghi analyses fraud among banks. Chapter 12 by Steven Dimmock, Joseph Farizo, and William Gerken examines fraud by investment advisors. Chapter 13 by Johan Sulaeman and Gennaro Bernile discusses how options backdating is a form of fraud. Stefano Paleari, Andrea Signori and Silvio Vismara provide an empirical analysis of misconduct in the context of pricing Initial Public Offerings, in Chapter 14. And in Chapter 15, Joseph McCahery and Alexander Roode examine the role of financial fraud through financial outsourcing to third parties and provide comprehensive survey evidence of the extent of the problems.

Part IV covers detection of market manipulation and financial misconduct. Chapter 16 by Mike Aitken, Anne Leduc and Sian Ji describes computer surveillance and technologies for detecting manipulation, and the computer software that is used by exchanges and their regulators. Chapter 17 by Ai Deng and Priyank Ghandi explains econometric and statistical tools to detect financial fraud. Chapter 18 by Professors Bannier, Ewelt-Knauer, Lips, and Winker provides an empirical review of Benford's Law and its application to detecting financial misconduct, with an illustration using data pertaining to the LIBOR scandal.

Part V provides an overview of financial market regulation relating to manipulation and fraud. Chapter 19 by Anita Indira Anand explains that empirical evidence around the world is consistent with the view that financial market regulation improves market efficiency and integrity and provides an in-depth analysis of regulation and enforcement issues in Canada and the UK. Chapter 20 by Mary Condon reviews issues surrounding registrant misconduct. Finally, Chapter 21 by Michael Firth, Oliver Rui and Wenfeng Wu provides empirical evidence supporting differential rates of enforcement depending on potential institutional biases, such as a "home court" advantage.

The coverage of each area of market manipulation and financial fraud in this book is summarized in Table 1.1. The range of topics is not completely exhaustive in this book. In some cases topics were excluded because authors faced confidentiality restrictions that precluded their publication. Nevertheless, we hope the broad range of materials in this book better informs and guides financial market participants, regulators, students, and academics alike. Individual cases of misconduct and outright fraud are reported frequently, whereas price and volume manipulation are so common that their occurrence is not usually conveyed to the general public. However, it is important to inform everyone about these practices, not only those directly participating in financial markets, because prices of final assets have a direct effect on the well-being of the global economy. We are, therefore, extremely indebted to the world leading authors that have contributed herein. We expect their analyses will continue to guide practice and policy for years to come.

Table 1.1 Summary of Coverage in Chapters

This table summarizes the topics in each chapter, and the scope of the chapters in terms of definitions, analyses of causes and/or consequences of fraud and misconduct, and case analyses or data. Panel A summarizes topics in financial market misconduct, Panel B summarizes topics in fraud. The different types of misconduct and fraud in the table are explained in detail in the chapters enumerated here.