WASHINGTON, DC - SEPTEMBER 19: SEC Chairman Mary Schapiro (3rd L) and commissioners (L-R) Troy Paredes, Elisse Walter, and Luis Aguilar listen during a meeting at the U.S. Securities and Exchange Commission September 19, 2011 in Washington, DC. The commission voted unanimous during the meeting on whether to propose a new rule under Section 621 of the Dodd-Frank Wall Street Reform and Consumer Protection Act to implement the prohibition under Section 621 regarding material conflicts of interest. (Image credit: Getty Images via @daylife)
It surprises most public investors that despite all the recent stock market crashes and data hiccups that there is no single comprehensive and readily accessible database regarding orders and executions. Instead of a unified database, each of the securities industry's self-regulatory organizations ("SROs") maintains its own separate audit trail system to track information relating to orders in its respective markets, resulting in an often Byzantine world in which no single, readily available snap shot of market data is available.
To critics of the present-day system of Wall Street regulation such as myself, this hodgepodge approach to trade data is akin to blindfolding the market's cops - and dangerously so in the face of fast moving tsunamis on the order of the recent Flash Crash. The last thing we need is for the SEC to be trying to contact several market centers over clogged phone lines or frozen online connections as the markets are melting down and panic is afoot. Unfortunately, that scenario isn't all that removed from reality.
On July 11, 2011, the Securities and Exchange Commission ("SEC") voted to require the national securities exchanges and the Financial Industry Regulatory Authority ("FINRA") to establish a market-wide consolidated audit trail ("CAT") in order to enhance regulators' ability to monitor and analyze trading activity. SEC Approves New Rule Requiring Consolidated Audit Trail to Monitor and Analyze Trading Activity (SEC Press Release 2012-134, July 11, 2012).
The new rules require that the exchanges and FINRA jointly submit a comprehensive plan detailing how they would develop, implement, and maintain a consolidated audit trail that must collect and accurately identify every order, cancellation, modification, and trade execution for all exchange-listed equities and equity options across all U.S. markets.
As explained in the SEC Press Release announcing the approval of the CAT rules:
[A]mong other things, the rule requires SROs to jointly submit a plan - called an NMS plan - to create, implement and maintain a consolidated audit trail. The rule specifies the type of data to be collected, when the data is to be transmitted, and how the data is to be prepared for regulatory use.
In particular, the rule mandates that the NMS plan:
Requires each national securities exchange and FINRA as well as their respective members to provide certain detailed information to a newly created central repository regarding each quote and order in an NMS security - and each reportable event with respect to each quote and order, such as its origination, modification, cancellation, routing, and execution.
Requires certain data to be reported to the central repository by 8 a.m. Eastern Time the following trading day - and be subsequently available in an aggregated format to regulators for their analysis.
Requires all reportable events to be tagged and stored by the central repository in a linked fashion allowing regulators to accurately follow an order through its entire life cycle from generation through routing, modification, cancellation, or execution.
Requires each broker dealer and national exchange to be assigned a unique, cross-market identifier to be reported to the central repository along with every reportable event.
Requires each customer as well as any customer adviser who has trading discretion over a customer's account to be assigned a unique, cross-market customer identifier to be reported to the central repository for every order originated.
Requires SROs and their members to synchronize the business clocks they use to record the date and time of any reportable event, and require timestamps - reported for each event to the central repository - to be in millisecond or finer increments.
The new rule becomes effective 60 days after its publication in the Federal Register. SROs are required to submit the National Market System ("NMS") plan to the SEC within 270 days of the rule's publication in the Federal Register. Once the SEC approves the NMS plan, the SROs are required to report the required data to the central repository within one year, and members of the SROs are required to report within two years. Certain small broker-dealers will have up to three years to report the data.
An SEC Sausage
Frankly, one wouldn't think that the creation of the CAT and its implementation would be the source of much friction on the SEC - think again. This is one sausage that you probably don't want to watch them make. Consider the disparate and often dueling views expressed by the SEC Chair and commissioners cited below.
Schapiro Draws The Line
In keeping with her role, SEC Chair Schapiro, sets forth the rationale for the CAT and the reasons that she supports the rule proposal. Opening Statement at SEC Open Meeting: Consolidated Audit Trail by Chairman Mary L. Schapiro (July 11, 2012) :
[T]hough FINRA and some of the exchanges currently maintain their own separate audit trail systems, there are numerous shortcomings regarding their accuracy, completeness, accessibility, and timeliness. These limitations make it impractical for regulators to readily follow orders as they are routed, aggregated, re-routed, and disaggregated across multiple markets.
For instance, after the Flash Crash of May 6, 2010, it took dozens of highly-trained economists, financial professionals, and data technologists four months to aggregate and process the information required to fully analyze just a few hours of trading on a single day. While that process was remarkable considering our limitations, and while we were able to identify the various causes of that event, efficient and effective market regulation requires that future analyses not take nearly that long.
In fact, it is even more difficult to perform some other types of market analyses because certain key information is never collected by audit trails - information such as the identity of the customers who originate orders, or the fact that two sets of orders may have originated with the same customer.
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.
First, a consolidated audit trail will increase the data available to regulators investigating illegal activities such as insider trading, wash sales, and market manipulation. In particular, increased data will facilitate risk-based examinations, allow more accurate and faster surveillance, improve the pr.ocess for evaluating tips, complaints, and referrals, and promote innovation in cross-market and principal order surveillance.
Second, a consolidated audit trail will significantly improve the ability of regulators to reconstruct broad-based market events in an accurate and timely manner. The sooner regulators can reconstruct the event, the sooner we can inform the public and determine what, if any, responses might be required.
Third, a consolidated audit trail will significantly increase the ability of regulators to monitor overall market structure, so that both the Commission and the SROs can be better informed about how our rules are affecting the markets. For example, having more precise data on the trading patterns of different types of market participants would help us better understand the impact of high frequency trading on the quality and fairness of our markets.
Finally, a consolidated audit trail will reduce the regulatory data production burdens on SROs and broker-dealers by reducing the number and types of ad hoc requests that regulators submit today. A consolidated audit trail that covers the entire market may also eliminate the need for multiple other, less efficient, reporting requirements that market participants must current comply with. . .
Sailin' On A Sea Change
Among the rules supporters is Commissioner Gallagher. Statement at SEC Open Meeting: Consolidated Audit Trail by Commissioner Daniel M. Gallagher (July 11, 2012).
[T]he NMS plan that will be required pursuant to today's rulemaking will ensure that in the near future, we will indeed have the information we need to smartly regulate today's complex markets, and aid us in monitoring and overseeing those markets. To be clear, this rule is a sea-change for the securities markets - it requires the reevaluation and revamping of key aspects of market infrastructure; it will provide the Commission with data and other information that is critical to satisfying our statutory missions, and allowing us to oversee the markets in a smart and efficient manner.
If it were not for the Dodd-Frank rulemaking frenzy that has dominated the SEC's agenda for the last two years, it would be abundantly clear that this rulemaking is a game changer. CAT is a tremendous step forward for the Commission, for the securities markets, and for investors, and I am pleased to support it. . .
Putting Reagan In A Ford
That's about as warm and fuzzy it's gonna get for Chair Schapiro. Commissioner Aguilar turns up the heat and turns down his thumb on the whole shebang. "Smart Regulation: Keeping the Door Open for Effective Ideas" by Commissioner Luis A. Aguilar(SEC Open Meeting, Washington, D.C. July 11, 2012):
[I] have been a consistent and vocal supporter of a consolidated audit trail.
. . .
Unfortunately, as currently structured, today's rule falls short of establishing the process that investors deserve. It is with great disappointment that I am not able to support today's rule. I am concerned that the proposal fails to set appropriately specific requirements to ensure the creation of a comprehensive market surveillance system, one that will capture the whole of the capital markets - including both regulated and currently unregulated markets. Moreover, I am concerned that the rule as currently drafted will limit innovation, and will fail to achieve cost savings.
[I] believe that the rule should not require that all the SROs jointly submit a single plan. Rather, the rule should provide the Commission with the ability to consider a fulsome discussion of competing solutions submitted by different sets of SROs. This would best serve the public interest and the protection of investors, by enabling the Commission to select the plan best designed to achieve the full range of benefits of a consolidated audit trail. As President Ronald Reagan once said, "excellence demands competition."
The release states that the decision to require all SROs to jointly file one NMS plan with the Commission "is appropriate because such a requirement is expected to result in an NMS plan that is the product of negotiation and compromise among all of the SROs…." However, this assumes that all SROs will have equal weight and negotiation power, which is just not realistic. The process contemplated by Rule 613 could result in a battle of size, not necessarily one of ideas. And, I might add, not all compromises represent improvement.
. . .
In my view, as I've considered this rule since its proposal, the best way to address cost concerns is through competition by encouraging the submission of multiple NMS plans. As Henry Ford once said, "[c]ompetition is the keen cutting edge of business, always shaving away at costs."9] Through the competition of ideas, the Commission would be in the best position to choose an NMS plan that will foster the creation of the most cost-effective, comprehensive consolidated audit trail.
Et Tu Brute?
Perhaps the most stunning rebuke came from Chair Schapiro's longtime cohort Commissioner Walter. Opening Remarks Regarding the Adoption of Final Rules for the Consolidated Audit Trail by Commissioner Elisse B. Walter (July 11, 2012):
[T]he rule before us today is a move in the right direction, since it could create the foundation of a consolidated order tracking system giving regulators more data elements than presently available. It also could provide other significant benefits, including the consolidation of order and trade information in NMS securities across all markets in one system, a uniform method of identification of orders and account holders, and a potential reduction in duplicative systems and the elimination of archaic ones.
However, although the rule before us today presents a positive step forward, I must respectfully dissent from its adoption.
While I continue to believe that the perfect should not be the enemy of the good, sometimes the good just isn't good enough. I really believe that this is a moment in which the Commission should be taking decisive steps to ensure that America's capital markets remain the world leader in fairness, capital formation and regulatory innovation. This is a moment when we should be guiding the SROs to leverage existing technology to create an efficient and effective source of market data that will serve regulators and the marketplace well today and for decades to come. Instead, we appear to be adopting an overly cautious approach.
I speak drawing upon my observations over the course of my career as a securities regulator and everything I have witnessed in the marketplace over the past four years during my service as an SEC Commissioner. I believe that the rule before us today falls far short of where we need to be in terms of bringing market oversight into the 21st century.
Considering that it has taken the agency three years to get to this adopting stage, and it will likely take several more years before any consolidated audit trail system is finally in place, the rule we consider today is disappointingly weak. As the release points out, the ultimate effectiveness of core SRO and Commission regulatory efforts depends on the accuracy, completeness, accessibility, and timeliness of audit trail data. Yet, the rule fails to set meaningful minimum requirements to assure that these important goals are achieved. Instead, the rule has been altered to be less prescriptive and hence less directional.
[M]y concern is that the release sets the stage for an uphill battle to reach a robust and effective consolidated audit trail system. With few if any firm standards to be met by the SROs, I fear that today's rule could lead to the path of least resistance and one that may only lead to incremental improvements using the existing OATS infrastructure, a system that was built more than a decade ago without the benefit of subsequent technological advances.
We seem to be placing the entire burden on the SROs to improve their audit trails without providing sufficient guidance. Yet, history teaches us that this type of advance is not frequently undertaken voluntarily. In fact, many existing SRO audit trail systems were created only as a result of Commission enforcement actions and the resulting settlement orders instituted against the SROs for their failure to adequately surveil their markets. . .
Bill Singer's Comment
Poor, poor, poor Mary Schapiro. Try as she might, she can't even get all the SEC's commissioners on board for something as compelling as a unified database for market data - one available in a consolidated format to assist regulators during fast-moving market breaks. Given the cliff over which we still hang, by the thinnest of nails, one would think that the folks sitting on the SEC could at least agree on a workable CAT program. Alas, not in this day and age of partisanship.
No one has yet to figure out the Flash Crash. There's that mess with MF Global. We still got questions for Goldman Sachs and JP Morgan's trading losses keep adding up. Then there's that whole Volcker Rule thing and the size of Bank of America and Wells Fargo and, geez, where did we leave off with that too-big-to-fail debate? Is the Facebook and Morgan Stanley IPO mess still on the docket - and are we doing anything about NASDAQ's role there?
And yet - still - many of you wonder why I persist in calling for the demolition of our entire regulatory system and to replace it with more facile and smaller components? READ: End the Politics of Wall Street Regulation: Decentralize FINRA and the SEC ("Street Sweeper" November 16, 2011).
What the hell happens when the Chair and commissioners at the SEC decide to order lunch? Can they even agree on where to call? When the food arrives, do they take out calculators to figure out how much to tip?
Hey, Gallagher, you had the cheesecake and nobody else ordered dessert, so you owe an extra buck towards the tip.
Walter, yeah, yeah, I know, there's no perfect solution to this tip thing but you still owe $1.25 from last week's lunch and I'm not covering again this week. If you're short, go ask Aguilar. Tell him that Reagan and Ford would help you out if they were here.
Uh, oh, not sure how to break this to you Mary but you know the corned beef on rye with mustard that you ordered? Well, looks like they put in on white with tomato, lettuce, and mayo. No pickle. And you got regular Coke instead of Diet.