The U.S. Securities and Exchange Commission adopted a rule today that would build a single system to monitor and analyze trading activity across U.S. equity and options markets.
In a 3-2 vote, the SEC’s members agreed to require securities exchanges and the Financial Industry Regulatory Authority to create a so-called consolidated audit trail that will enable the reconstruction of market crises and analyze trading on 13 equity exchanges, 10 options markets and more than 200 broker-dealers that execute stock trades away from public venues. The effort is part of the agency’s response to the May 6, 2010, stock rout that temporarily erased $862 billion in U.S. equity value.
"A consolidated audit trail that accurately tracks orders throughout their lifecycle and identifies the broker-dealers handling them will provide us with an unprecedented ability to effectively oversee the markets we regulate," said SEC Chairman Mary Schapiro.
The SEC has already implemented circuit breakers to halt trading when a company’s shares move 10 percent in five minutes. Still, Schapiro has pressed for tools that would allow faster and broader oversight of trading activity. After the 2010 market disruption, it took a 20-person SEC team three months to collect and process quote and trade data that arrived in different formats from exchanges and brokers.
Schapiro, a political independent appointed by President Barack Obama, had to rely on the support of Republican Commissioners Troy Paredes and Daniel Gallagher to adopt the rule. The two Democrats on the SEC, Elisse Walter and Luis Aguilar, opposed the measure, saying it doesn’t go far enough.
Real-Time Reporting
Walter said the SEC should have required real-time trade reporting, which exchanges fought as too costly. The rule adopted today would require data to be reported by 8 a.m. the following day.
"Not striving" for a real-time reporting regime "seems to ensure that the industry remains one step or one day ahead of the regulators," Walter said.
The Securities Industry and Financial Markets Association had opposed real-time monitoring. The next-day standard adopted by the SEC "is a more manageable and cost-effective approach to this kind of system," Randy Snook, SIFMA’s executive vice president, said in a statement after the vote.
Gregg Berman, a senior adviser to the director of the SEC’s division of trading and markets, told commissioners at the end of their meeting that real-time reporting doesn’t provide better information than the next-day standard.
Record-Keeping System
The so-called consolidated audit trail will enable the reconstruction of market crises and analyze trading on 13 equity exchanges, 10 options markets and more than 200 broker-dealers that execute stock away from public venues.
Momentum for the proposal increased after it took the SEC and Commodity Futures Trading Commission five months to complete a report on what became known as the flash crash, in which the Dow Jones Industrial Average briefly plunged 9.2 percent. While the CFTC needed several weeks to compile its data, a 20-person SEC team spent three months collecting and processing quote and trade data that arrived in different formats from exchanges and brokers, according to Gregg Berman, senior adviser to the director of the SEC’s division of trading and markets.
"This is very significant," Edward Kwalwasser, New York- based senior counsel at Proskauer Rose LLP and a former New York Stock Exchange and SEC official who worked on the commission’s market oversight and surveillance system known as MOSS in the early 1980s, said in a telephone interview. "When we did MOSS the technology wasn’t available to accomplish our ends. Today it clearly is. This will give the SEC a real running start in being able to surveil all the markets in a fair way."
Monitoring Trading
Regulators currently keep tabs on the markets and monitor trading using data collected in different formats. The consolidated audit trail would be a centralized data hub that captures "customer and order event information" throughout the life cycle of a transaction, according to the proposal. An aspect of the plan requiring data to be submitted to the repository in real time was dropped in February after exchanges and brokerages said it would be too costly and unnecessary for enforcement actions that may take days or weeks to conduct.
Plan’s Roots
The roots of the plan go back to 1980 when Congress authorized $12 million for the SEC to build a computer system to oversee markets because legislators were concerned exchanges were failing to do an adequate job monitoring trading, Kwalwasser said. The pilot program was dropped when exchanges and the predecessor organization to Finra established methods to share information and meet surveillance duties such as monitoring for suspicious activity and pursuing insider trading.
"With the grilling the SEC took in front of Congress after the flash crash, they didn’t want to have to rely on anybody else — they wanted to get information that was as complete as possible themselves," Kwalwasser said. The SEC is pursuing a consolidated audit trail without claiming that the exchanges "haven’t lived up to what they’re supposed to do, even though trading has become harder to track," he said.
Market Fragmentation
The supervision of equity and options markets has exploded in complexity since the 1980s as regulations led to more venues competing for quotes and trades while exchanges and Finra installed systems to assemble order and transaction data for the products they oversaw such as stocks listed on NYSE or Nasdaq. Abusive trading dispersed across multiple venues became harder to track than activity centralized in one place. The New York Stock Exchange accounted for 22 percent of trading in the companies it lists last month, compared with 87 percent in 1980, according to data compiled by Bloomberg and NYSE.
Once the exchanges and Finra present a national plan to establish an audit trail, it will be subject to SEC approval before being implemented. The agency estimated in its 2010 proposal that the exchange and brokerage industry would need to spend $4 billion to set up the central repository and develop related systems. Annual ongoing costs would be $2.1 billion.
Finra and Nasdaq OMX Group Inc., the operator of Nasdaq Stock Market, each told the SEC last year that they could be the technology processor for the audit trail. Finra gave the SEC a blueprint in April 2011 for the timeline it would adopt to build the record-keeping system on top of its current order audit trail system, or OATS. Implementing the system for equities would cost no more than $125 million, Finra said, not including the expense of integrating options, bonds, swaps and other products, which the SEC wants.
Nasdaq Comments
Nasdaq OMX told the SEC in a November 2011 letter not to "lower its expectations" by turning to a system such as OATS that doesn’t meet the agency’s needs. The exchange operator said it could build the system the SEC envisions. The exchanges and Finra will be responsible for selecting the technology provider or plan processor that would operate the repository for the audit trail data, the SEC said in 2010.
Thomas Jordan, president and chief executive officer of Jordan & Jordan, a New York-based firm specializing in securities industry information and compliance issues, said he hopes the exchanges and Finra will put out a request for proposal to select the service provider that will be the plan processor. More clarification is also needed on how the audit trail initiative relates to the tracking system implemented to monitor activity by brokers, high-frequency firms and asset managers deemed large traders by the SEC, he said.
"It would be good for the SEC to be part of the creation of the plan," Jordan said in a phone interview. "I can’t overemphasize how complicated creating this will be. If the SEC stays involved and doesn’t just throw it over the wall, we could get a stronger result. Maybe we could also come up with more than one alternative and the SEC can choose among them."
