An SEC Computer to Peer Into Wall Street's Dark Pools
Around 2:30 p.m. on May 6, 2010, the U.S. stock market began to crash. It fell 600 points in five minutes, erasing about $800 billion in value. The market largely rebounded by day’s end, but investors were spooked. It took the U.S. Securities and Exchange Commission more than four months to piece together what had happened: A single trader’s order to unload $4 billion in futures contracts caused a price dip that set off a cascade of automated selling. The Flash Crash, as it was dubbed, made obvious what had been true for years—the stock market is so fragmented that computers processing orders at lightning speed can trigger a selloff before anyone spots a problem. “The idea that the regulator of the largest-capital market in the world didn’t have a consolidated view across all the different trading venues … seemed to be a glaring issue that needed to be remedied,” says former SEC Chair Mary Schapiro.
Four years later, bidding is under way to build a powerful computer to give federal regulators that fuller view of the way the market works. The Consolidated Audit Trail, or CAT, will be one of the largest databases in the world, designed to funnel 50 billion daily records into an archive. The computer will track every stock quote, order, and trade, including when and where transactions occur, the brokers who handle them, and the customers they represent. The CAT will pull data from the 18 U.S. public stock and options exchanges and the private trading venues run by banks, known as dark pools, that don’t have to immediately report data to the SEC.
If it works as planned, the CAT will improve the SEC’s ability to scrutinize parts of the market it can already see and shine a spotlight on the places it currently can’t. More than 30 percent of trading occurs outside the SEC’s field of view , either in dark pools or inside large wholesale brokerages that match buy and sell orders internally. The computer will be able to flag suspicious patterns suggesting insider trading. All that data will also help to answer an especially nagging question: Is the market rigged in favor of high-speed traders?
“That’s exactly why the SEC wants the CAT,” says Craig Lewis, a Vanderbilt University finance professor who stepped down as the SEC’s chief economist in May. “It’s great that it will let you monitor potential insider trading, but I view that as a second-order benefit to conducting market research designed to inform future rule making.”
At the moment, though, the CAT is still more hope than reality. Two years after the SEC approved its creation, it hasn’t been decided who will build the computer and how much it will cost. Congress is prodding the agency to hurry. On July 29, Democratic Senator Mark Warner of Virginia sent a letter to Chair Mary Jo White urging her to “expedite the completion of the CAT” and also to “appoint a CAT director” to oversee the program.
The project is moving slowly in part because the SEC is allowing the public financial exchanges and the Financial Industry Regulatory Authority (Finra) to run the bidding process that will choose a company to build the CAT and decide how much to spend on it. Finra isn’t a government agency but a private nonprofit, funded with fees from the exchanges, as well as from the Wall Street brokerages it regulates.
The idea was to let an industry consortium take responsibility for meeting the government’s demands without imposing a new bureaucracy on the markets. The SEC doesn’t have the budget or know-how to build something as complex as the CAT. The exchanges already collect large amounts of trading data, which Finra uses to watch over them. Finra also compiles trading records it gets from brokers into databases, such as the Order Audit Trail System (OATS). But by letting go of the CAT, the SEC is ceding power to the industry it oversees. “The CAT is moving like a glacier for a reason,” says Dennis Kelleher, president of Better Markets, a nonprofit promoting tighter regulation of the markets. “It’s not exactly in their interest to be quick about this.”
On Sept. 30, Finra and the exchanges are scheduled to deliver to the SEC a plan spelling out how the CAT data will be secured and who will pay for the system. Brokers don’t want to bear the cost alone and argue that the exchanges should kick in part of the money. If the agency approves the plan, the industry consortium will then select a winning bid. The computer won’t be fully up and running until at least 2018. The SEC declined to comment on the CAT.
Dozens of companies put in bids to build the system. Google teamed up with software multinational SunGard. Hewlett-Packard joined with McLean (Va.)-based government contractor Booz Allen Hamilton. IBM put together its own proposal. The D.C. consulting firm Promontory Financial Group collaborated with the American division of India’s Tata Group. Although the bids are secret, two people inside the industry who are familiar with some of them say they have ranged from about $170 million to almost $1 billion to build and operate the CAT for five years.
One of the bidders is attracting special scrutiny: Finra itself made a proposal, meaning it’s competing for the contract that it’s also partly in charge of awarding. Finra says it’s gone to great lengths to sequester the 170 people assigned to work on its bid from the 22 employees who are helping to run the competition. Outside lawyers were brought in to make sure the sides stay separate. “We knew that we would be looked at to see how we managed this,” says Finra Senior Vice President Marcia Asquith. “People are trying to be careful.”
It’s easy to see why Finra would want to keep its hands on the controls. Once the CAT goes live, Finra’s OATS database will become redundant and probably be shut down. If Finra loses the bid to build the system, its control over market data could be undermined, diminishing the organization’s influence and possibly costing it revenue. Finra says it has plenty of sources of revenue and that its survival doesn’t depend on winning the CAT contract. “Would we be disappointed? Yes,” says Tom Gira, executive vice president for market regulation. “Is it the end of the world? No.”
Last month, Finra and the exchanges narrowed the bids to 6 from 10. IBM and Promontory are no longer in the running. SunGard and HP still are—and so is Finra.
On July 29 about 150 people packed a conference room in Manhattan to get a first look at the bids. The meeting, which was closed to the public, was attended mostly by Wall Street professionals who will feed their trading data to the CAT and pay the fees to fund it. Among them were a handful of high-frequency traders, who are surprisingly welcoming of the extra surveillance of their work. They say the system could help lift their stigma as villains of the market. “The CAT will separate the bulk of speed traders from a handful of bad actors who practice manipulative strategies,” says Peter Nabicht, a senior adviser at the Modern Markets Initiative, a high-frequency trade group. “I think the data will ultimately exonerate us in the minds of a lot of people.”