Saturday, September 14, 2013
Toughen Up SEC Rules
The government should mandate higher standards and tighter compliance for the exchanges’ technology. Last week’s brief shutdown was just the latest snafu.
Would a proposed Securities and Exchange Commission rule have prevented the three-hour outage at Nasdaq in late August or the six-minute version that occurred last week? Probably.
The SEC is readying Reg SCI (Systems Compliance and Integrity) to replace and expand portions of the commission’s Automation Review Policy (ARP), which covers trading technology and systems. With their 60-day comment period finished, the Reg SCI rules—designed to get a better handle on Wall Street’s technology infrastructure and create more trading stability—are in a revision period with the implementation date still unclear. SEC Chairman Mary Jo White is a strong advocate. In many cases, the rules make mandatory what has been voluntary, and the industry has opposed them, mostly based on the cost of implementation.
Reg SCI would impose new standards on “key market participants,” such as exchanges and certain alternate-trading systems, clearing agencies, and automated systems that directly support trading, clearance and settlement, order routing, market data, regulation, and surveillance. Also covered would be the self-regulatory organizations: the Financial Industry Regulatory Authority (Finra) and the Municipal Securities Review Board. The SEC has said 10 dark pools, or private trading platforms, are large enough to be regulated, based on their 2012 volumes.
AFFECTED MARKET PARTICIPANTS would be required to establish, maintain, and enforce policies and procedures to ensure that their systems can operate and promote fair and orderly markets, and that they comply with all laws and regulations. They are also required to correct any system disruptions or compliance issues and to notify the SEC of system changes. Disaster-recovery plans would have to be tested at least annually, with a report on compliance to authorities.
Frankly, it’s surprising to me that such policies and procedures are still voluntary, given recent history. Nasdaq OMX Group (ticker: NDAQ), which is slated to brief the SEC this week about the Aug. 22 breakdown, has said that problem occurred because of a massive number of data requests from a rival exchange, NYSE Arca, that came in above tested limits. Nasdaq’s securities-information processor failed to handle the extreme message traffic. The messages included requests for price quotes.
In May 2010 came the “Flash Crash” that caused nearly $1 trillion in temporary paper losses; and in 2012 a tech snafu at Knight Capital led to the firm’s losing millions of dollars and ultimately being sold. Another tech failure: Facebook’s (FB) disastrous initial public offering, which spurred Nasdaq to make good on up to $62 million in systems-related losses.
Most responses to the proposed regulations are, rather predictably, against the added burden of new rules and requirements. Finra says, in its comment letter of July 8, 2013, that while it supports the goals of the proposed regulation, it is “concerned that the scope of Regulation SCI may be overly broad and may potentially encompass a large number of systems, perhaps unintentionally, which could diminish the overall focus and effectiveness of the proposal.” Finra considers the proposal too rigid, and would like the entities involved to have more discretion and flexibility in adopting their own policies and procedures. Its 43-page response makes numerous requests for clarification, using the phrase, “unclear and potentially overly burdensome” dozens of times.
Others suggest the industry has adequate incentives to fix the problems.
Not everyone on Wall Street agrees. One trading executive, who spoke on the condition of anonymity, insists tougher regulation is needed. He believes that, given their size, importance, and risk, the exchanges should be treated like public utilities and regulated as such. “They have a critical public function to fulfill,” he says.
Dave Lauer, a market-structure and technology-architecture consultant, thinks the regulations should also apply to broker-dealers, and has said that, “anybody with direct market access should be covered by Regulation SCI and have stringent and robust technology standards imposed on their processes.” The emphasis on competition has overwhelmed the need for stability.
Clearly there is room for greater technological stability. We will continue to monitor the state of these regulations, and how they affect the retail trader.
Published in Barron’s, September 9, 2013