The Securities and Exchange Commission spent 21 years seeking a system to monitor America’s largest stock traders. It took a 20-minute market plunge to convince the securities industry it was a good idea.
New rules that allow the SEC to track the 300 biggest firms will help U.S. regulators reconstruct crashes, police violations and curb behavior they don’t like, according to industry executives and academics. The proposals, blocked twice by brokerage professionals before resurfacing prior to last year’s equity rout on May 6, were spurred by a 1990 congressional authorization called the Market Reform Act.
“There was significant opposition, with firms raising questions about cost and around foreign competition,” Mike Corrao, head of compliance for equities at Jersey City, New Jersey-based Knight Capital Group Inc., said in a phone interview. The May 2010 crash that erased $862 billion from stocks in 20 minutes persuaded brokers the SEC needs a “fast and efficient mechanism to gather trading data from the largest market participants,” he said.
SEC Chairman Mary Schapiro has advocated an identification system for more than half her career. While an SEC commissioner in 1990, she said the plan -- part of “awesome new powers” from Congress -- would let the agency monitor participants that engage in a “substantial level or value of securities trading” and scrutinize their impact on the markets.
The five SEC commissioners voted unanimously on July 26 to require the largest traders to register with the SEC and brokers to track them through identification numbers. Attempts to approve the program in 1991 and 1994 were squashed by the securities industry, which said compliance would be too cumbersome and costly.
The program will allow the SEC to connect trades in one market to stock or options transactions in another, something it can’t currently do, said Larry Harris, a former chief economist at the SEC who’s now a finance professor at the University of Southern California’s Marshall School of Business in Los Angeles. That will expand knowledge of what traders are doing and improve regulations, he said in a phone interview.
“The SEC is the primary regulator of the securities markets and needs to be well informed,” Harris said. “They need to know who’s trading and they need to understand the context in which people do their trades.”
April 2010 Proposal
The large-trader reporting mandate, announced by the SEC in October 2009 and proposed in April 2010, augments the Electronic Blue Sheets system, which brokers use to respond to SEC requests for data. Now, securities firms will be required to track the identification number of traders and the date and time transactions occur. Brokers must also review the market for large traders that aren’t using an identification code.
“The politics of this changed dramatically after the hiccup that occurred in May 2010,” James Cox, a Duke University law professor in Durham, North Carolina, said in a phone interview. “Everybody understood that we couldn’t have this Wild West, unobserved frontier.”
Brokers and investors saw they were at risk if the SEC couldn’t figure out what happened in the crash, Cox said. The complexity of the U.S. securities market, with 13 stock exchanges, more than 40 dark pools and nine options bourses, complicates the task of compiling and analyzing data. Dark pools are private venues that don’t display bids and offers.
May 6 Crash
The May 6 plunge prompted a review by the SEC staff that included as much as 10 terabytes of market data, according to a May 18, 2010, report from the agency. Twelve days after the rout, the agency conceded that it couldn’t offer a firm answer on what caused the selloff.
The reporting requirements will help the SEC understand how stock market crashes happen and what the biggest firms do in times of unusual volatility, said Sean Culbert, a partner at consulting firm Capco in New York. “Root cause analysis” can’t be conducted without knowing where trades are coming from, he said. The system will also allow regulators to prove whether someone front-ran a stock or basket of shares.
“If the SEC sees a pattern of trading ahead of large blocks from the same or different organizations, it can find out whether there’s collaboration between firms or within a firm,” Culbert said in a phone interview. Since a broker only monitors its own trading, “you need a regulator to understand what’s occurring among firms,” he said.
The SEC estimated the rule will apply to about 400 large traders and 300 brokers, with most of the costs borne by the securities firms. Automated trader Getco LLC in Chicago and fund managers T. Rowe Price Group Inc. in Baltimore and Boston-based Wellington Management Co. are likely to qualify, based on letters they sent the SEC.
People or companies that transact at least 2 million shares or $20 million of securities in a day, or 20 million shares or $200 million in a month, are covered by the rules, according to the SEC. The single-day share figure represents less than 0.03 percent of the average daily U.S. equities volume of 7.5 billion shares in the first half of 2011, Bloomberg data show.
Large traders must identify themselves to the SEC by early December. Once the SEC assigns a firm an identification number, the trader must provide it to brokers so they can maintain records starting in May. The data must be available to regulators the morning after a request.
Advances in technology since the 1990s make it easier and cheaper for brokers to track clients, Andrew M. Klein, a partner at Schiff Hardin LLP in Washington who advises exchanges and investment managers, said in a phone interview. He was director of the SEC’s division of market regulation in the 1970s.
“Commentators said, ‘It will be very expensive, you don’t understand the complexity of broker-dealers’ and hedge funds’ accounts, it will be a big mess and we don’t have the automation to do this,’” Klein said. “Today, with the markets electronically interlinked and broker-dealer automation at a high level, the large-trader system doesn’t pose the technological challenges it did in the early 1990s.”
SEC officials in the 1990s wanted to understand how unregulated hedge funds affected the market. Now regulators want more data on high-frequency traders, whose computers send, update and cancel orders in fractions of a second. Firms that rely on the techniques account for more than half the volume in U.S. equity markets, the SEC said last year.
From Aug. 1 through Aug. 10, when the Standard & Poor’s 500 Index plunged 13.3 percent amid surging volatility, high-frequency firms tripled their volume and may have accounted for 75 percent of U.S. shares changing hands, estimated Gary Wedbush, executive vice president at investment bank Wedbush Inc., whose broker subsidiary services many of the firms. Wedbush was the largest provider of liquidity, or bids to buy shares and offers to sell, on the Nasdaq Stock Market in the first six months of this year, according to exchange data.
The SEC predicted it would send 100 requests for large-trader data annually to each affected broker. It issued 5,168 blue-sheet requests from the beginning of 2007 through the first half of 2009. While fewer inquiries will be issued to the biggest traders, they’ll cover more securities and longer time periods, the SEC said.
‘Piece it Together’
Elizabeth Derbes, a New York-based partner at Wilmer Cutler Pickering Hale & Dorr LLP who works with broker-dealers on regulation and compliance, said that while the SEC can now gradually compile the data it will soon be able to access more easily, “as a practical matter it would have been very tough to piece it together.”
“It’s a big win for the regulatory world,” Culbert said. “If they can execute more exams for less money, then it’s a good thing.” The efficiency of SEC examinations should increase and “if the SEC is going down a not-useful path, they can cut their losses quicker,” he said.
Regulators will be able to figure out who’s doing what “as of T-plus-1,” Dan Mathisson, New York-based head of electronic and program trading at Credit Suisse Group AG, said in a phone interview, referring to the day after the transaction date. That will give the SEC information they need “to be more proactive and address issues quicker,” he said.
Should buying increase before a takeover, the SEC can quickly see who the biggest acquirers were and whether their behavior raises questions, Mathisson said. They can also track anyone engaged in a practice known as quote stuffing, or the rapid submission and cancellation of orders, he said.
Programming and testing computer systems to comply with the large-trader rules will cost $31.8 million for all 300 brokers, the SEC said. Annual reporting requirement expenses will be $16.2 million while monitoring for unidentified traders will be $4 million initially and $1.2 million a year. The total initial cost for the 400 large traders to register with the SEC and give their identification codes to brokers will be $1.3 million, with $998,000 incurred annually, the SEC estimated.
Knight’s Corrao said the estimates are probably too low for brokers. He cited the cost of establishing the tracking procedures, checking the reports and monitoring customers for the presence of unidentified large traders.
Derbes said in a phone interview that fund managers and trading firms may struggle to quantify whether they qualify for the program. Compelling some affiliates to use the SEC-assigned number may be “similarly tricky,” she said.
“It could be operationally difficult for them to keep track of this,” Derbes said. “Some of these may be far-flung, minority-owned affiliates, including foreign affiliates.”
U.S. regulators may also have to improve computer systems to deal with their new data-gathering capabilities.
“The SEC needs to be better equipped to analyze the data it collects,” said Harris, the former chief economist at the securities commission. “The SEC has some quantitative expertise but would need a lot more resources to effectively analyze these data.”
Large-trader reporting will also strengthen the SEC’s planned consolidated audit trail that will aggregate all quotation and trading information for U.S. securities. The commission proposed the system on May 26, 2010, less than three weeks after the May 6 plunge. Identifying large traders will let the agency see what the biggest players did at times of market stress, Duke’s Cox said.
The audit trail is projected to cost exchanges and brokers $4 billion to build and $2.1 billion a year to maintain, the SEC initially said. Klein, the former head of the SEC’s market regulation division, said one area the agency will be able to investigate once the programs are running is so-called mini crashes that occur in individual stocks.
“The SEC will be able to figure out why there’s an imbalance in supply and demand right at any millisecond,” he said. “If they find a concentration of activity that affected a particular stock or vulnerable part of the market, they can investigate it. Today, being unable to see who the large participants are isn’t acceptable.”
Although identification of the biggest firms will give the SEC tools to analyze fast-paced markets and pursue violations of securities law, proving a trader tried to manipulate prices or influence supply and demand will remain difficult, Cox said.
“The SEC will have better insight into what happens with the pricing of securities and is likely to adopt rules that will be prophylactic, which will make it less likely that market manipulation could occur,” Cox said. “But we won’t judge the success of these programs by how many scalps are hung up.”