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SEC developing new fraud detection technology

The U.S. Securities and Exchange Commission (SEC) headquarters stands in Washington, D.C., U.S., on Wednesday, Oct. 26, 2011. The SEC approved a rule requiring hedge funds and private-equity funds to reveal internal information to U.S. regulators. Photographer: Andrew Harrer/Bloomberg (Andrew Harrer/BLOOMBERG)

The Securities and Exchange Commission plans to launch computer software this year to spot accounting anomalies, including potential fraud, in the financial statements that companies file with the agency.

The software would scan a firm’s financial disclosures, assess risk factors and generate a score based on a model developed by the agency, Craig Lewis, the SEC’s chief economist, said in a recent speech. The score would be used to identify outliers within a peer group.

“It is a model that allows us to discern whether a registrant’s financial statements stick out from the pack,” said Lewis, who also heads the agency’s risk, strategy and financial innovation division.

The software is scheduled to be available in nine months.

The effort is the most recent sign of the agency’s commitment to beef up its technological prowess as it tries to better police Wall Street and avoid oversight lapses such as the ones that allowed Bernard Madoff’s Ponzi scheme to go undetected for years.

The SEC has acknowledged that it lags behind the industries it regulates when it comes to technology, in part because of a tight budget that is subject to the whims of Congress. While nearly all financial regulators operate on fees collected from the industries they oversee, the SEC’s funding is decided by lawmakers on a year-to-year basis. Uncertainty about the budget makes it difficult to commit to technology or upgrade it.

The SEC took that into account when it embarked on its most ambitious technological endeavor in recent history — a software package that will stream real-time trade data from the exchanges into the agency’s headquarters. Rather than build the technology from scratch at great expense, the agency purchased it from a New Jersey firm called Tradeworx. The project, called Market Information Data Analytics, or MIDAS, is in the final testing phases.

The new software is based on a model that the SEC has used to evaluate hedge fund returns and identify fraud, mostly by looking for performance that was inconsistent with a fund’s investment strategy. The agency has brought seven cases based on information culled from that project since 2011.

“This success has only fed our ambition for what we can do with sophisticated data-driven monitoring programs,” Lewis said. The goal is to make use of the “veritable treasure trove of information” that the SEC regularly receives from companies.

The new software would focus on accounting anomalies.

Under the 2002 Sarbanes-Oxley law, the SEC must examine the financial filings from public companies every three years. But only recently have all companies been required to file those forms in a digital format with computer-readable tags that make it easy to search for and compare items of data, either for a single firm over time or across companies.

The new software would search for unusual accounting by looking at various risk factors such as frequent changes in auditors or delays in the release of earnings. But it would not be used solely to detect fraud. It could also pinpoint areas in which companies can improve the quality of their financial disclosures, Lewis said.

Dina ElBoghdady covers housing policy for The Washington Post.



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