The 32-year wait for a comprehensive record-keeping system to monitor trading across U.S. equity and options markets is approaching conclusion.
The Securities and Exchange Commission is meeting tomorrow to consider adopting a proposal issued three weeks after the stock rout of May 6, 2010, to build a single system to track all order and trading data.
Stock exchanges will not have to report trades in real-time under a rule set to be finalized by the SEC that would create a trail of market activity, according to a report by Reuters.
The SEC's draft final rule is expected to instead require exchanges to submit trading data by 8 a.m. the following day, according to sources cited by Reuters.
Exchange operators such as NYSE Euronext and brokers such as TD Ameritrade objected to real-time reporting as originally proposed in May 2010 by the SEC, saying it would be too costly and provide little benefit to regulators.
The SEC had estimated the consolidated audit trail could cost $4 billion upfront and $2 billion a year to operate. The industry would have to cover the cost.
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%. While the CFTC needed several weeks to compile its data, a 20-person SEC team spent three months collecting, cleaning and processing data from exchanges and brokers because of a lack of uniform quotes and trade data, 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.”
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 weeks to conduct.
The SEC will consider issuing a rule tomorrow instructing the exchanges and Financial Industry Regulatory Authority, which oversees about 4,400 brokers, to “develop, implement and maintain a consolidated audit trail” for all equity securities and options, according to a notice from the agency released July 6. The system will collect data “across all markets, from the time of order inception through routing, cancellation, modification or execution,” according to the statement.
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.
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 when activity was centralized in one place. The New York Stock Exchange accounted for 22% of trading in the companies it lists last month, compared with 87% 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 provider for the audit trail. Finra gave the SEC a blueprint in April 2011 for the process it would use 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 cost of integrating options, bonds, swaps and other products.
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.
Jamie Selway, head of liquidity management at Investment Technology Group Inc., a New York-based brokerage, said it’s likely that governance of the national plan won’t be spelled out at the SEC meeting. The issue is important to brokers who want a say in how the system that compiles their data will use or handle the information. The technology provider for the system won’t be selected either, he said.
“We’re not expecting finality,” Selway said in a telephone interview. “It’s a pretty good piece of policy that we should have had a long time ago.”
Here’s how one market data aggregator, Nanex, says a non-realtime reporting system can work, for under $4 billion:
Really, $4 Billion? That is absolutely ridiculous. A subscription to a feed like NxCore, a private "regulators only" database that matches existing exchange sequence numbers to trader IDs, and people to run it would cost a tiny fraction of that. And would have minimal impact on existing infrastructure.
There is no need to track orders, messages or trades in real time. If all participants know that the SEC can, at any time in the future, go back to any trading day and pluck out some misdeed -- that will be more valuable and significantly less expensive than attempting the impossible feat of real time monitoring.
Here's why the goal of real time monitoring is not only foolhardy and pie-in-the-sky impossible, but a tremendous waste of resources.
Wall street hires the best software wizards money can buy. They write clever algorithms. These algorithms will only get more clever as time goes on and they will always changing. It is 100 times more difficult writing algo detection software than writing the algos in the first place, which in the software world means at least 100 times more expensive. Which means hiring people that do not exist, since Wall Street already snapped up the best, and you need the best times 100. You can't make it up in quantity and just get 100 times as many wizards, because many have poor social skills, and you need these people to communicate.
But, let's say the SEC or whoever runs the consolidated audit trail does in fact manage to hire wizards 100 times smarter than the best on Wall Street. Are they going to be able to instantly write, debug, test and deploy new code to match new algorithms that can appear at any time? How about after a day? A week? Without a doubt it will take much more time to write new detection code than it took Wall Street to write the new algo code. And let's not forget, Wall Street doesn't want it's algos being detected.
But, let's say by some incredible stretch of the imagination (software sales guys, you have to love them!) that it is possible to roll out new detection code instantly without a hitch. Now what? The monitor goes beep, beep, beep, red lights blaring. What now? You can't have a human in that loop, because by the time their brain processes the alarm, the damage is already done. Even at the speed of the flash crash (which was glacial compared to today), it would have been over before any phone call could have been made.
But, let's say the machine could automatically "take action" on alerts. Oh yeah? Let's go back to the day of the flash crash. What time would the alarm have gone off? You sure? Really sure? What about false alarms? Managing the signal to noise ratio is incredibly difficult when processing financial data streams.
But, let's say the SEC has the best of the best of the best who never fail and the real time monitoring software correctly detects the problem at exactly the right time and never misfires. Let's pretend the alarm went off at 14:42:44, which in hindsight, after thousands of hours of analyzing billions and billions and billions of records, is the time we are pretty sure that day went from bad to abnormally bad. It's 14:42:44 on May 6th and the alarm goes off. What now?
We have the world's most perfect software detecting a once-in-a-decade freak event about to happen. What is going to do about it? Stop the market right then? How? Which market? What about those outside the SEC/CFTC jurisdiction? Just the futures market? Or equities too? Options? Index calculations? Derivatives? How will this software physically do "the something" to prevent the crash? It would have to transmit some sort of signal to every entity involved. There are millions of subscribers to real time data in the U.S. alone. How will it prevent everyone who is watching the market halt on CNBC from panicking or doing stupid things in areas not related to trading? Like clearing grocery store shelves, grabbing the kids, the shotgun and the wife and heading for the hills.
But, let's say (last stop in fairytale land, I promise) that the world's most phenomenal software detects a once in a decade event at the precise time of intervention and manages to do the right thing that stops an impending crash and nobody panics. How will these networks be protected from exploitation? How will it be kept secure?
Do you see the folly of trying to regulate the markets in real time? Real time raises the cost exponentially times a million. To a level that all the kings in the world couldn't afford. It would be one thing to track in real time, things that had known behavior. Like your checking account being overdrawn. Maybe credit card fraud in the making (which, by-the-way is a much simpler problem and hasn't been perfected despite lots of money and time).
In summary, all the SEC has to do is demonstrate that they can, at anytime in the future, go back to a day in question and find the bad guy. To achieve this takes only a few simple steps.
1. Get an existing data feed and archive the information so it can be processed anytime in the future.
2. Have each exchange create a new database where every exchange message has two keys: the existing public exchange sequence number and a new private trader id.
3. Hire competent people to write software that can detect anomalies anytime in the past and have them provide exchange sequence numbers of any messages involved.
4. Match up exchange sequence numbers to trader id's and find the bad guy.
5. Enforce existing regulations fairly and with conviction.