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CFA® Level III · Ethical and Professional Standards · free lesson
Guidance for Standard II: Integrity of Capital Markets
Capital markets work only if investors believe prices reflect information that is fairly available and trading that is genuine. Standard II protects that belief by prohibiting trading on material nonpublic information and market manipulation. At Level III you must apply these rules to portfolio managers who are wall-crossed, run private and public strategies side by side or are paid on period-end values, and recommend the firm controls that keep information and prices honest.
What you will learn
1. Determine whether information is material and nonpublic, apply the mosaic theory, and identify the actions such information rules out.
- Material: likely to affect the price or important to a reasonable investor; judge specificity, reliability and expected price impact.
- Nonpublic: not yet disseminated to the market in general; selective disclosure does not make information public.
- Do not trade, recommend or tip until the information is public or no longer material; tell compliance.
- Wall-crossings, creditor committees, expert networks and pending large orders are common Level III sources.
- Mosaic theory: public plus nonmaterial nonpublic information may be combined even if the conclusion is material.
2. Distinguish legitimate trading and research from information-based and transaction-based market manipulation.
- Manipulation requires intent to mislead; price impact alone is not manipulation.
- Information-based: false rumours, misleading research, pump-and-dump schemes.
- Transaction-based: wash trades, spoofing, marking the close, squeezes and corners.
- Honest negative research with a disclosed position, tax trades and large investment trades are legitimate.
- Period-end trading in illiquid holdings by managers paid on valuations is a classic warning sign.
3. Recommend firm policies, such as information barriers, watch and restricted lists and wall-crossing procedures, that protect market integrity.
- Information barriers confine material nonpublic information to the team that needs it, with compliance controlling every wall-crossing.
- Watch lists are confidential monitoring tools; restricted lists stop trading but can signal a deal.
- A total halt in proprietary trading is not required and can itself leak information; restrict and review instead.
- Small firms that cannot separate staff should use stricter controls such as broader restricted lists.
- Asset managers need policies for wall-crossings, expert networks and private-credit teams that sit next to public-equity teams.
Module at a glance
- II(A): do not trade, recommend or tip on information that is both material and nonpublic.
- Wall-crossings, creditor committees, expert networks and pending large orders are typical Level III sources.
- The mosaic theory allows conclusions built from public and nonmaterial nonpublic information.
- II(B): manipulation requires intent to mislead; price impact alone is not enough.
- Spoofing, wash trades, marking the close and squeezes are transaction-based manipulation; false rumours are information-based.
- Information barriers, watch lists, restricted lists and compliance-controlled wall-crossings protect market integrity.
- Small firms need stricter controls, and a firm-wide trading halt is neither required nor wise.
This free module has 3 lessons, 14 practice questions with full explanations.