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SEC Votes to Require Consolidated Audit Trail for Markets

The Securities and Exchange Commission voted yesterday to require exchanges and a broker oversight group to build a single system to monitor and analyze trading activity across U.S. equity and options markets.

In a 3-2 vote, the SEC approved a rule requiring the exchanges and the Financial Industry Regulatory Authority, which oversees 4,400 brokers, to establish a so-called consolidated audit trail that will enable the reconstruction of market crises and expedite surveillance across 13 equity exchanges, 10 options markets and more than 200 broker-dealers that execute stock trades away from public venues. The effort is part of the agency’s response to the May 6, 2010, stock rout that temporarily erased $862 billion in U.S. equity value.

“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,” said SEC Chairman Mary Schapiro. The rule is a “great leap forward,” she said.

The SEC has already implemented circuit breakers to halt trading when a company’s shares move 10 percent in five minutes and required market-makers to supply quotes closer to the best prices than was previously required. Still, Schapiro has pressed for tools that would allow faster and broader oversight of trading activity across U.S. venues. After the 2010 market disruption, a 20-person SEC team needed three months to collect and process order and transaction data that arrived in different formats from exchanges and brokers.

Measure’s Strength

Schapiro, a political independent appointed by President Barack Obama, had to rely on the support of Republican Commissioners Troy Paredes and Daniel Gallagher to adopt the rule. The two Democrats on the SEC, Elisse Walter and Luis Aguilar, opposed the measure, saying it doesn’t go far enough.

Walter said the SEC should have required real-time order and trade reporting, which exchanges fought as too costly and unnecessary to meet the agency’s surveillance and enforcement needs. The rule adopted yesterday would require some of the data to be reported by 8 a.m. the following day.

“Not striving” for a real-time reporting regime “seems to ensure that the industry remains one step or one day ahead of the regulators,” Walter said.

Next-Day Standard

The Securities Industry and Financial Markets Association had opposed real-time monitoring. The next-day standard adopted by the SEC “is a more manageable and cost-effective approach to this kind of system,” Randy Snook, Sifma’s executive vice president, said in a statement after the vote.

Gregg Berman, a senior adviser to the director of the SEC’s division of trading and markets, told commissioners at the end of their meeting that real-time reporting doesn’t provide better information than the next-day mandate. Data can also only be used after it’s been checked, orders and trades hailing from the same source have been linked, and the information has been aggregated and made available to regulators, he said.

“The only advantage of real-time data is that an analysis might start sooner but not that it will be better,” Berman said.

Regulators currently keep tabs on the markets and monitor trading using data stored in different formats. The consolidated audit trail would be a centralized data hub that captures order information throughout the life cycle of a transaction, from when the buy or sell request is generated to how and when it’s routed, modified, canceled or executed. Each broker, exchange and customer would have an identifier that’s reported to the repository so information can be linked back to the same source.

More Data

The consolidated audit trail will give the SEC’s enforcement division more data to pursue insider trading and market manipulation investigations, Steve Cohen, an enforcement official, said in the meeting. It will also permit the agency to more easily examine all activity by a trader and not just the behavior that provoked the investigation, he said.

The lack of access to customer information has hindered and slowed the division’s investigations, hiding potentially manipulative activity and forcing the SEC to “cobble together data from disparate systems, each incomplete, inaccurate, inaccessible and untimely in their own way,” Cohen said. The planned audit trail should remedy the problem by enabling the SEC to identify linked accounts and pursue trading that appears suspicious more rapidly and confidentially, he said.

Devising Specifics

The SEC’s approval leaves it to the self-regulatory organizations that operate exchanges and Finra, the private-sector regulator for brokers, to develop the specifics of how the consolidated audit trail will work in practice. The SEC must approve the plan before it can be implemented.

“This is an important step that will address cracks in our fractured market system,” Senator Charles Schumer, a Democrat from New York, said in an e-mailed statement. “The SEC should follow through and require high-frequency traders who impose the highest costs on the system to bear the largest share of the burden for implementing the consolidated audit trail.”

Regulators will be able to use data collected through the audit trail to study the strategies of market participants including high-frequency trading firms and their impact on the “quality and fairness” of the market, Schapiro said. The exchanges and Finra must specify how the costs to build and support the consolidated audit trail will be distributed across the SROs and their broker-dealer members, according to the SEC. Many high-frequency traders are brokers.

Plan Deadline

The exchanges and Finra must submit their audit trail plan within nine months of the rule’s publication in the Federal Register, according to the SEC. The public will be able to comment on that plan. If the SEC approves the initiative, the SROs would begin reporting data to the repository a year after the plan becomes effective. Bigger brokers would have one more year before they must report quote and trade data to the repository while smaller firms would get two years.

While today’s action was a step in the right direction, it’s “disappointingly weak,” Walter said in the SEC meeting.

“Sometimes the good just isn’t good enough,” she said. “We appear to be adopting an overly cautious approach.”

The rule should have been more prescriptive and laid out “minimum requirements” for the accuracy and completeness of the data, according to Walter. The commissioner also said she worried the SEC may settle for only “incremental improvements” to its oversight capabilities if the planned record-keeping system is built on top of an existing audit trail maintained by Finra and built a decade ago. “We need far more,” she said.

Finra’s Blueprint

Finra told the SEC last year it could be the technology processor for the consolidated audit trail. It gave the SEC a blueprint in April 2011 for a timeline 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 expense of integrating options, bonds, swaps and other products, which the SEC wants. The exchanges and Finra will be responsible for selecting the technology provider or plan processor to operate the repository for the audit trail data, the SEC said in 2010.

“We are not going to throw this rule over the transom and say to the SROs, ’Come back to us with whatever you think works here and we’ll be happy to approve it,’” Schapiro said at the closing of today’s meeting. “We’re going to stay intimately involved. We’re going to have to push and pull and make sure that the plan meets our standards.”

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