[author: David Smyth]
On July 11th, the SEC adopted Rule 613, a rule that requires national securities exchanges and FINRA “to 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.” That sounds pretty wonky, and it will take a while for that plan to come together, certainly months and maybe years. But in the end, it could be great. To understand why, consider where we’ve come from.
As the SEC’s press release said, “[c]urrently, there is no single database of comprehensive and readily accessible data regarding orders and executions.” Instead, each self-regulatory organization, including the NASDAQ, FINRA, the Chicago Board Options Exchange, among others, uses its own system to track information relating to orders in its respective markets. Existing audit trail requirements vary significantly among markets, which means that regulators must obtain and merge together large volumes of disparate data from different entities when analyzing market activity. As I’ve written before, collecting this data at the SEC is a remarkably cumbersome process. And given the advances in high speed trading around the world over the last few years, it should be a minor scandal that the SEC’s processes for getting that trading information have been allowed to languish for so long.
A consolidated audit trail will change all of this, bring all of these systems together, and deliver trading information to the SEC in a (nearly) continuous feed.
Old-Style Enforcement, but Faster
Many seem to be ready for the SEC to get a handle on high-speed trading and think the audit trail will help the agency toward that goal. Others cite the May 2010 flash crash as an incident that will be more easily remedied once the SEC has easy access to the trades that caused it. Well, maybe. The consolidated audit trail will certainly make it easier for regulators to get to the roots of high speed trading and problems that it might cause for markets. And untangling another flash crash will also be a more manageable task with all of the trading data in place. But having the data and understanding the data are two different things. Fully loaded spreadsheets will not easily answer why a cascading string of failures have caused share prices in particular issuers to fall drastically in a matter of minutes. Arriving at that answer will still require smart people to pore over and make sense of the numbers.
But the data will quickly make some types of more “regular” securities enforcement much easier. Insider trading suspicions will not have to wait for a month or more while data requests are issued by SEC staff and then answered over a matter of weeks. Suspected Ponzi schemes that are doing no securities trading at all will be much more easily exposed. These sorts of violations – not exactly space-age – will likely be the first targets with the new tool.
A number of commenters on the proposed rule objected that real-time trade reporting would be too expensive to implement. The Securities Industry and Financial Markets Association, in particular, estimated that the cost per broker-dealer to implement real-time reporting could be millions of dollars and that the cost of capturing options in real time along could exceed the Commission’s $2.1 billion estimate for the yearly cost of the audit trail. The final rule settled on reporting by 8:00 a.m. of the following day. I think this will turn out to be a reasonable compromise that gives regulators the tools necessary to do their jobs effectively without imposing an undue burden on the securities industry. Getting the numbers by early the next trading day will be sufficient.
Jointly Submitted Plan
Commissioner Luis Aguilar voted against passing Rule 613 for a number of reasons. He seems to be primarily concerned that the SROs are required to jointly submit a single plan to comply with the rule. He would instead have each SRO submit its own plan and let the best ones compete for passage by the SEC. Commissioner Aguilar may be right that such a plan would be better than one jointly submitted by the SROs, but I suspect that the improvements would be marginal. And the additional time it would take to separate the winner(s) from the rest could be considerable.
Unique Customer Identifiers
Another area where the SEC backtracked from its initial proposal in 2010 was on the requirement of a unique customer identifier that would identify a trading customer across all broker-dealers. The final rule has less stringent requirements in this respect and will require unique identifiers to be reported to a central repository “for every order originated” and “along with every reportable event.” As the excellent Themis Trading blog noted:
Why is this so important? Because many [high-frequency traders] are not brokers and go through a sponsored access broker. Essentially, they would still be masking their activities underneath their sponsoring brokers shield. Things like wash trades, for example, will be very difficult to identify under the newly approved audit trail.
Commissioner Walter voted against the final rule partly because of this issue. In explaining her vote, she said, “[I]n some cases, [the audit trail] would only reveal the entity named on the account rather than the actual individuals controlling it. In short, the rule’s flexibility may well result in less timely, complete and accurate information and therefore less effective market oversight.”
I don’t know where to come out on this aspect of the rule, but it is an issue worth watching. I do think as a whole that the consolidated audit trail will result in more effective policing of the securities markets, and will certainly put the SEC lightyears ahead of where it has been.