The United States Securities and Exchange Commission’s approval to move ahead with a consolidated audit trail that tracks all U.S. stock market trades in the biggest securities data venture ever undertaken, drew immediate complaints that the agency is moving too slowly for government critics and too fast and rich for the securities industry.
The long-awaited decision comes even as the world’s largest financial firms are investing heavily in the new disruptive technology ‘blockchain,’ a digital ledger that many believe can deliver the type of secure and continuous audit trails envisioned by the SEC and other regulators.
The SEC plan attempts to steer a middle ground on its three-year phased-in system of reporting securities trades, trying to placate both sides by rolling out the system in steps and trying to minimize the cost by limiting the speed trading requirements in the early stages.
But critics say that the timetable could mean the system will be obsolete on arrival, and many expect delays and high costs regardless of what the SEC decides. With technology moving quickly, the first step in moving the plan forward may involve rethinking some of the basic assumptions, and even working incorporate blockchain, the technology behind the digital currency bitcoin.
“Given the size and scope of this project, I would expect delays beyond the three-year implementation timeline initially proposed, in addition to cost overruns,” said James Mullen, chief technology officer of Firm58, a trading systems firm.
Google vs Amazon in “big data” battle
The audit trail, known as the CAT, initially drew dozens of bids from companies battling for the prize of building the highly visible and high-ticket venture. The number was whittled down to three finalists , including Amazon and Google as the main technology providers working in partnership with market regulators.
The plan already was pushed back a year amid concerns over privacy voiced by the membership of the Financial Industry Regulatory Authority, the largest self-regulator in the securities industry. While some of those complaints have been addressed, others remain. The SEC has allowed an additional 60-day comment period to air the many concerns of a broad array of constituents involved in the plan.
“There will also be pushback and delays from the market participants who will be required to modify their systems to collect and integrate data for the consolidated audit trail,” said Mullen.
The commission approved the plan 30, but not without expressing reservations from both sides. “Developing and maintaining the CAT is going to be an incredibly costly endeavor,” warned Commissioner Michael Piwowar, a Republican, who urged more study on the costs. An industry trade group, the Securities Industry and Financial Markets Association, or SIFMA, said it supports the concept but sees the timetable as unrealistic.
From paper to warp speed trading
Market regulators, as well as the Internal Revenue Service, have long pushed the securities industry to tackle the problem of tracking the beneficial owner of a security for its entire life span. The issue grew in importance as electronic trading replaced stock certificates and tracking systems were not updated to store information in industry standard formats. Regulators, meanwhile, began building data systems to register and monitor trading that required each firm’s mostly proprietary systems to conform, but in a limited number of data sets.
The initiative to create modern, uniform data repository gained urgency when regulators tried to reckon with fallout from the so-called “Flash Crash” of 2010, in which a flood of sell orders caused shares to plunge $1 trillion in value in a matter of minutes. Regulators were unable to reconstruct the market moves in the aftermath to find what caused the collapse, largely because huge volumes of orders hit the market from remote, anonymous algorithmic traders, some allegedly using illegal high-speed manipulation. It led to calls for a CAT system that could document all trades by stamping them with unique identifiers down to millisecond requirements. The SEC approved the concept in 2012.
Foot travel in supersonic age of markets
Since the initial plan was approved high-speed trading has gained momentum, and Commissioner Kara Stein said the 50 millisecond requirement proposed initially is already outdated.
“At the speed at which today’s trading is done, this is like requiring police officers to travel by foot while the rest of the world travels by supersonic jet,” she said at the SEC meeting last week when the plan was approved.
The version drafted will raise the speed requirements gradually, in one of the major cost concessions backed by SEC chair Mary Jo White.
When the CAT was first proposed it was described as “the world’s largest data repository for securities transactions tracking approximately 58 billion records of orders, executions, and quote life cycles for equities and options markets on a daily basis.” The capacity was five times the highest average volume in peak trading times. Ironically, since the 2008 financial crisis equity trading volumes have declined.
But the trading volume is higher in dollar terms and carried out in a widening array of alternative venues along with an explosion of new financial products. Equities trading is down, but volume is rising in options, futures and exchange traded funds, which add to the demands for a CAT system to track markets effectively.
CAT system, like herding cats
“A true collaboration among all market stakeholders will be vital to an effective CAT, especially as we consider the security and technology considerations that have arisen since the SEC proposed the CAT,” said Sifma’s Randy Snook, executive vice president business policies and practices, in a statement after the SEC approved the plan. He said the proposed timetable is too tight to afford the time required to bring all affected parties together.
The SEC maintains that the cost of the system will involve a hefty initial outlay by firms and that the burden will eventually level off as the cost of running the network is distributed to all users. But cost estimates have varied widely, ranging from $1 billion to $4 billion, in a cost-sharing formula yet to be determined. The securities industry has lobbied for broad cost sharing that would include market-makers and investors.
CAT made for blockchain?
Some see a potential solution over the horizon as blockchain technology becomes available, with its “distributed ledger” that creates an encrypted security that can be updated with data at each transaction. A system using blockchain technology could carry as many lines of data as required and help allocate the costs of data management to each owner from the time a security is created.
“Blockchain is inevitable,” said Jeff Dennis, an industry consultant and former head of digital transformation at BBVA Compass at the CDO Summit this week. He said the four largest U.S. banks have invested $1 billion in the technology.
The CAT system is “exactly the kind of application that blockchain is made for,” said Firm58’s Mullen. It could be as secure way to encode securities from their inception and could carry all of the data that a Big Data repository can handle without the massive server and data entry requirements of a cloud system.
In an example of how serious companies are taking blockchain, IBM announced last week new services to help companies design and develop blockchain technology in a secure environment in the cloud, a network of computers where users are increasingly storing their data and computing work.
James Wallis, vice president at IBM, told a New York conference that the company was using blockchain to develop a “compliance ledger,” that would allow auditors to view transactions in a secure and realtime system. The auditable operating environment that IBM envisions would include comprehensive log data that supports forensics and compliance.
“The goal is real-time audit,” said Wallis.
In a recent McKinsey report “Beyond the Hype: Block Chain in Capital Markets,” the consulting firm said “blockchains contain detailed and precise histories of asset movements that can be made transparent for authorized compliance activities.”
“With customer and dealer books on the same ledger, requirements relating to anti-money laundering or customer order handling can be efficiently addressed,” McKinsey said.
The problem with blockchain
But participants have yet to decide the uniform standards to create a centralized blockchain standard to build networks of users. What’s more, said Mullen, even if industry standards are agreed and the CAT consortium buys into the concept, the encryption remains slow and costly and the expertise to convert the entire securities world would be difficult to find.
“One can imagine a world in which securities lending, repo, and margin financing are all traceable through blockchain’s transparent and open approach to tracking transactions,” said SEC Commissioner Kara Stein at a Harvard conference last year. “That could revolutionize regulators’ approach to monitoring systemic risk in these areas, including the oversight of collateral reuse, to name just one potential use.”
Some major firms are already at work to apply blockchain to securities transactions. The Depository Trust and Clearing Corporation, one of the world’s largest clearing firms, recently announced plans to develop and test a distributed ledger based solution to manage the clearing and settlement of U.S. Treasury, agency, and agency mortgage-backed repurchase agreement (repo) transactions. Repo agreements were selected for this proof of concept because there is an opportunity to streamline how these products are cleared, as repo transaction volumes continue to grow.
The proposals to do the work on CAT involve the two biggest players in Big Data, Google and Amazon, who hope to create a system that employs their massive data processing in a system that touches the entire financial world. Blockchain thus far has not been part of any proposal to handle the SEC’s CAT.
The SEC staff does not talk about proposals during the public comment period, said John Nester, spokesman for the agency. Specific questions on proposals are referred to the selfregulatory agencies. Ray Pellecchia, spokesman for the Financial Industry Regulatory Authority, one of the bidders for the CAT work, said blockchain is not part of the authority’s proposals. The consortium setting an industry standard did not respond to questions about how blockchain specifications might fit its schematic, which puts a heavy reliance on large scale data warehousing technology, as opposed to distributed ledger.
The SEC, which ultimately will decide which bidder to use, “is very aware of blockchain” and its potential use in securities registration, said a regulatory source in Washington, and its use will likely to considered before the process is finalized. “Blockchain technology has the potential to modernize, simplify, or even potentially replace, current trading and clearing and settlement operations,” said SEC Chair Mary Jo White in a recent outlook in which she rated it as one of the three top financial technology priorities for the agency. “We are closely monitoring the proliferation of this technology and already addressing it in certain contexts.”
“It’s out there as a very good solution, it has everything a CAT system needs,” said Mullen. “But it could take ten to fifteen years to get there.” Judging the progress on the plan so far, some might say, that could be just in time.
About Thomson Reuters Regulatory Intelligence
This article was produced by Thomson Reuters Regulatory Intelligence, and initially posted on May 3, 2016. It was written by Richard Satran and Henry Engler, senior writers for Thomson Reuters Regulatory Intelligence.
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