Regulation SCI’s Hidden Costs May Cause Sticker Shock

How much are institutional investors willing to pay for improved market resiliency and fewer IT crashes? They're about to find out and they may want to be sitting down when they ask for estimates.

Now that Regulation Systems Compliance and Integrity or Reg SCI was approved by the SEC yesterday, the financial ciommunity is full of questions. First and foremost is, how much is this going to cost us?

Although the SEC can sum up the scope of Reg SCI in three bullet points, SCI entities and non-entities are concerned over the investment they will need to make to comply with the 104-page proposed rules.

With Reg SCI’s approval, the industry has its doubts.

James Angel, associate professor at Georgetown Universitys McDonough School of Business, views Reg SCI as the old death by 1,000 paper cuts. He said that it would require firms to allot more operational resources to meet the new regulatory requirements on top of their existing investments to improve their cyber-security, tax-reporting and anti-money-laundering systems.


If you think of it from an incentive perspective, every participant already has really good incentives to make sure its systems do not fail, Angel explained. No one wants to be the next Knight Capital Group. The threat of instant bankruptcy, which changes over every technology-based trading firm, is the best possible incentive. No amount of rule-making will come up with a better incentive to have people do their job better.”

In fact, Angel said he believes that Reg SCI will produce the opposite of improving the overall market health and resiliency in the long term.

What it adds up to is much higher operating costs and firms will need to amortize those costs and that means a higher cost of doing business, he said. Larger firms would have advantages over smaller ones and, at the end of the day, it means less competition, which is not good for the customer.

No one quite knows how much of an investment companies will need to make to meet the requirements, added Theodore Lazo, managing director and associate general counsel at SIFMA. We believe the cost of the proposed rule is difficult to quantify given the vagueness of various provisions of the rule.

That said, some of the buyside is aware how onerous Reg SCI might be, given their responses to the SECs thoughts about including transfer agents − firms that keep track of which publicly traded securities companies own, and some of which are owned by large asset managers − and other entities under Reg SCIs regulatory umbrella.

The role ofentities in the securities markets and the associated risks that other entities present must be taken into account when understanding whether Regulation SCI should be expanded toincludethem. Or else theproposed regulation will impose burdens on firms, shareholders and investors without producing commensurate benefits, said Ari Gabinet, executive vice president and general counsel at OFI Global Asset Management.

Entities like transfer agents and clearing brokers do not pose the same level of risk that SROs and ATS operators do, since they conduct their activities after the trade is made and a temporary outage would have little material effect on market-wide trading, order routing, market data or other critical functions, added Scott Goebel, general counsel at Fidelity Management and Research. Moreover, Regulation SCI is designed to formalize the commissions existing ARP program. Given that clearing broker-dealers and transfer agents are not currently included in the ARP program, we do not believe that they should be included in the regulation formalizing this program, he said.

Inside Reg SCI’s Mission

Regulation NMS modernized the U.S. cash equities market structure almost a decade ago, and Reg SCI seeks to accomplish the same thing for the markets resiliency. The proposed regulation aims to reduce the chance of technology glitches shuttering a portion of the overall market, and ensure that key entities can take the appropriate corrective actions if a market meltdown occurs.

It is far from the first time that the SEC has tried to make sure Wall Street has its market infrastructure in order. After the Black Monday crash of October 1987, the regulator developed its Automation Review Policy (ARP) and subsequent ARP II policies. These voluntary programs suggested that self-regulatory organizations (SROs) establish comprehensive plans to test the capacity and venerability of their automated systems, conduct regular stress tests on their systems, and consult third-parties annually to assess the SROs capacity and security planning.

The May 6, 2010, flash crash, where the Dow Jones Industrial Average dropped approximately 9 percent and rebounded in minutes, demonstrated the weakness of the ARP programs. This incident was at first attributed to a “fat finger” mistake, but it required the SEC and sibling regulator U.S. Commodity Futures Trading Commission (CFTC) to take months researching its cause before attributing it to a large number of e-mini S&P 500 contracts made by mutual-fund company Waddell & Reed. This was detailed in the regulators joint report, published in September 2010.

As part of the flash crash fallout, then SEC Chair Mary Schapiro held a technology roundtable with market participants in which they examined how the industry and the SEC could promote more stability in the markets, drawing on, somewhat poetically, the best practices that the Federal Aviation Administration had developed for investigating aviation crashes.

Armed with this knowledge and additional research, the SEC, led by interim Chair Elisse Walter, unanimously proposed Reg SCI and its 60-day comment period in March 2013.

Unlike the SECs previous market-resiliency policies, the regulator plans to make Reg SCIs rule mandatory for the market, as well as covering more than SROs under its umbrella.

As currently written, the proposed rule would designate SROs, alternative trading system (ATS) operators that meet a certain trading volume threshold, securities information processors (SIPs) and certain clearing agencies that are exempt from SEC registration (read: Depository Trust & Clearing Corp.s Omgeo business).

Those designated SCI entities would need to make sure that their key systems meet certain standards; conduct regular business continuity testing with members, partners or participants; and provide certain notifications to the SEC and its members regarding systems disruptions and other systems issues.

Large asset managers like BlackRock, Fidelity and OFI Global Asset Management (OppenheimerFunds), as well as industry organizations like the Securities Industry and Financial Market Association (SIFMA), the Investment Company Institute (ICI) and the Managed Funds Association (MFA), support Reg SCIs goals.

Clearly, it is in everyones best interest to prevent technological error, as well as examine the most efficient response to that, said an ICI spokesperson. ICI has therefore supported efforts in this area; we believe many of the steps already taken to address market risks have improved the ability of the market to respond to market disruption events.

When, Not If

At press time, the SEC had not released the final version of Reg SCI, even though it closed its extended comment period on July 8 and scheduled final action on the rule for early October.

Recent press reports attribute the SECs inaction on the matter to party-line conflict between the commissioners. Luis Aguilar and Daniel Gallagher are the only SEC commissioners remaining from when Reg SCI was first proposed in March 2013. The Senate confirmed Chairman Mary Jo Whites nomination to the SEC in April 2013, and commissioners Kara Steins and Michael Piwowars nominations in August 2013.

Republican SEC commissioners Gallagher and Piwowar are not known for going along for the sake of going along, according to Georgetowns Angel: They will not approve it unless they actually approve of it. I do not know what their opinions are, but they do not seem to hesitate in voting no on things that will not do a lot of good.

Democratic-appointed Chairman White and Aguilar have spoken in favor of the rule, while fellow commissioner Stein has played her cards close to her vest without commenting publicly on the proposed regulation. However, she has gone on record in the past supporting market structure reforms.

But it is only a matter of time before the regulator eventually makes its move, according to Georgetowns Angel.

It has too much regulatory momentum to disappear, and the Flash Boys phenomenon has put a lot of political pressure on the SEC to do something, he said. The SEC has stated it was working on Reg SCI, and it would be a huge embarrassment for White if it does not go through in some form.