SEC’s consolidated audit trail at risk again, this time by funding

A massive database the Securities and Exchange Commission is developing to improve its supervisory capacity of financial firms is once again in flux.

The latest threat: The firms under scrutiny by the regulator’s data dives are rejecting a plan that makes them responsible for funding it.

Back in 2011, the SEC first planted the seeds for the system. Following a massive “flash crash” in 2010, it adopted Rule 613, a plan to create a consolidated audit trail (CAT) that allows regulators to efficiently and accurately track all trading activity throughout the U.S. markets.

Among other things, the rule required self-regulatory organizations to jointly submit a plan to create, implement, and maintain the system. It also specified the type of data to be collected and when the audit trail data is to be reported to a central repository.

National securities exchanges and SROs were expected to provide detailed information to the created central repository regarding each quote and reportable event with respect to each quote and order, origination, modification, cancellation, routing, and execution.

After abandoning the idea of real-time reporting, the SEC agreed that the data must be reported to the central repository by 8 a.m. EST the following trading day and be available to regulators for their analysis.

Once the CAT is active, each broker-dealer and national securities exchange will be assigned a code that uniquely and consistently identifies them and links them to transactions.

“With the approval and ultimate implementation of CAT, the Commission’s regulatory capacity strongly embraces 21st century technology, enabling the Commission and the SROs to harness data and technology to more effectively oversee market participants,” Mary Jo White, chairman of the SEC at the time, said. “Through the CAT, regulators will have more timely access to a comprehensive set of trading data, enabling us to more efficiently and effectively conduct research, reconstruct market events, monitor market behavior, and identify and investigate misconduct.”

Despite White’s optimism, there have been numerous roadblocks along the way to developing and implementing the system. There was, for example, issues surrounding clock synchronization among covered firms, SROs, and the database.

Over time, many of these details were worked out. In January 2017, the SROs’ Selection Committee of the CAT NMS Plan selected Thesys Technologies as the plan processor. Amazon and Google were among the firms offering their cloud storage expertise and bidding for the contract.

With a vendor selected, the CAT system was slated to begin operation in 2018. That schedule is now threatened by a funding fight.

“The total number of quotes, orders, and trade executions, which would be roughly equivalent to messages, would also be a better measure than share volume for impact on CAT costs.”
Daniel Zinn, General Counsel, OTC Markets Group

The SEC has estimated that building the CAT system’s core repository will cost nearly $92 million. Annual operating costs will be around $135 million. The biggest cost: nearly $4 billion in implementation, reporting, and compliance costs. 

Among the Commission’s new problems is the budget plan under consideration by President Trump and Congress. It may slash the SEC’s traditional $50 million reserve fund, largely used for technology enhancements. Since 2012, the Commission has spent nearly $205 million on IT improvements and initiatives.

The House Financial Services committee’s recently advanced Financial CHOICE Act would also remove the reserve fund, arguing that it should be under Congressional control and oversight.

COST, REDUNDANCY & DATA SECURITY

The following is from a July 18 letter from the  Securities Industry and Financial Markets Association to the Securities and Exchange Commission regarding the National Market System plan governing the Consolidated Audit Trail.
SIFMA has supported the development of the CAT and believes that, if successfully implemented, the CAT will be a critical aspect of market infrastructure, and provide an invaluable opportunity to enhance the information capture and reporting structure that exists today.
This comment period is critical because there are a number of important issues in the CAT proposal that we believe must be resolved before the plan is approved and before the CAT’s construction begins. These issues fall into a number of categories that SIFMA and its members have identified as priority concerns as the Plan and CAT move forward.
Elimination of systems: The CAT has the potential to provide significant ancillary benefits to regulators and member firms alike. Key among these will be the elimination of redundant reporting systems. SIFMA believes there are certain steps the SEC and self-regulatory organizations can take that will increase the likelihood that all parties will not only reap these benefits, but do so sooner and more thoroughly than currently contemplated by the plan.
Cost and funding: SIFMA has repeatedly raised CAT funding as a critical issue that requires collaboration between the SROs and broker-dealers. SIFMA urges the SEC to call upon the SROs to address a threshold question at the outset: namely, whether there has been sufficient justification offered in the CAT Plan to require broker-dealers to bear any of the financial burden of funding a system that exists to receive and process information that broker-dealers are required to report under SEC regulations. In addition, we urge the SEC to direct the SROs to engage an independent third party to provide an objective and transparent analysis of the CAT funding issues.
Data security: Keeping CAT data secure and confidential is of primary importance not only to the efficacy of the system itself, but also to the confidence of market participants. It is therefore imperative that the CAT be held to the highest security standards, with particular focus on ongoing security and confidentiality of information transmitted to and stored within the CAT and the primary importance of securing customers’ personally identifiable information.
Governance: The CAT should be overseen in a transparent manner that delivers strong collaboration between the SROs and their members. As such, broker-dealers should be integrally involved in CAT governance, with full voting rights. In the alternative, however, we provide specific recommendations on the Advisory Committee structure, designed to ensure it operates as an effective, integrated part of the CAT governance.
Data use: The development of the plan has included very little discussion of how the SEC and the SROs will actually use the CAT data.
Operational Issues: SIFMA raises operational issues implicated by the CAT reporting structure as currently proposed. These include issues with respect to clock synchronization, time stamp on allocations, primary market transactions, and legal entity identifiers.
Source: SIFMA

That budget cut, however, is nearly irrelevant as the primary source of funding is under fire over the fees to be assessed to brokers, exchanges, banks, and other firms.

In a June letter, New York-based OTC Markets Group sounded the alarm over the proposed rule change adopting a fee schedule. General Counsel Daniel Zinn called the plan “unfair and anti-competitive.” He suggested, on behalf of the firm, “a more equitable approach that would align fees with the resource usage and costs associated with each execution venue.”

A better metric for measuring market share would be number of trades, as this would better align the costs of operating CAT with the fees charged to exchange venues and industry participants, Zinn wrote.

“The total number of quotes, orders, and trade executions, which would be roughly equivalent to messages, would also be a better measure than share volume for impact on CAT costs,” he added.

“OTC Markets Group urges the SEC to protect investors in the OTC equity markets and the public interest in capital formation by abrogating the unfair and disruptive CAT Fee Schedule and requiring it to be re-filed,” the letter concludes. “In addition, we ask that the SEC conduct an economic study on the impact of the CAT fees on execution venues and other market participants.”

The Securities Industry and Financial Markets Association (SIFMA)—which represents securities firms, banks, and asset managers—has also been critical of the costs, but remains hopeful for how the system will ultimately work.

“The development of the CAT presents a singular opportunity to build a state-of-the-art regulatory system that can enhance regulatory oversight while replacing redundant, legacy reporting systems that require significant resources to operate,” Randy Snook, executive vice president, said in January. “The timely elimination of redundant regulatory requirements, robust data security practices, and the establishment of an equitable funding model are mission critical to establishing a CAT system that enhances regulatory oversight without adding unnecessary complexity or risk.”

In a July 28 comment letter, however, the organization expressed its concerns about the fee structure and its transparency.

“Our ability to provide a thorough analysis of the proposals is hindered because the SROs have provided no real data to support the proposals,” the letter to the SEC says. “Rather, the SROs have simply established a fee structure that imposes a vast majority of the CAT costs to the broker-dealer community and then presented the plan as a fait accompli.”

There are key questions that the SROs must answer, “to allow market participants an opportunity to provide for a true analysis of the fee proposals,” SIFMA wrote. Among them:

What are the real costs to build and operate the CAT? And how have they been calculated?

What are the terms of the contract between the SROs and Thesys to build and operate the CAT?

What will be the usage costs for CAT when it is built and operable?

“Absent this information, it is impossible for market participants to determine if the proposed funding models are either reasonable or equitable,” SIFMA wrote.

It requested that the SEC direct the SROs to provide the “necessary information, including any underlying data that was relied upon in the development of the funding models, in order to provide market participants with the opportunity to better assess and, if needed, propose equitable alternatives.”

The lack of data is also reflected “in the comparability standard that the SROs have devised in the CAT plan,” the letter says.

“Rather than considering the true impact of reporting or usage in the building and operation of the CAT, the SROs have simply determined that the CAT fees should be ‘comparable’ between the largest exchange complexes and the largest broker-dealer complexes and among the SROs themselves,” the letter says. “The notion of ‘comparability’ is one that the SROs have created themselves in order to suit their own purposes. This standard is not reflected in the Exchange Act or any rules thereunder.”

“The fact that the SROs have created a self-serving standard and then asserted that it is axiomatic does not mean that it satisfies the requirements of the Exchange Act,” it adds.