The securities industry has raised significant questions and concerns about the Large Trader Reporting Rule, the latest in a series of rule changes proposed by the SEC this year to increase oversight of trading activity. The proposed rule would require traders who engage in substantial levels of trading activity to identify themselves to the regulator, which would assign each trader a unique identification number. Large traders would provide the number to their broker-dealers, which would be required to maintain transaction records for each large trader and report that information to the SEC upon request.
The object of the rule is to identify and obtain "certain baseline information about traders that conduct a substantial amount of trading activity … and to analyze significant market events for regulatory purposes," according to the proposed rule filing. This fairly open-ended language has been widely understood to imply that the SEC is interested in investigating the trading activities of high-volume and high-frequency traders in particular - a group that, some say unfairly, has been targeted as the root cause of the May 6, 2010, "Flash Crash" and has been accused of generally lowering the quality of the investing experience for less technologically advanced players.
Despite its name, the rule does not pertain to block trades; rather, it is intended to provide visibility into the thousands of small trades that are transacted in milliseconds and dispersed among many trading centers. A "large trader" generally would be defined as a firm or individual whose transactions in exchange-listed securities equal or exceed 2 million shares or $20 million during any calendar day, or 20 million shares or $200 million during any calendar month.
"The high-frequency traders are the ones they're concerned about," says Gary LaFever, general counsel and chief corporate development officer at FTEN, a provider of low-latency execution and risk monitoring services to broker-dealers and sponsored traders. "They tend to throw out a ton of small orders, which are aggregated across the day, not per trade."
The logic appears to be that the huge spikes in trading volumes and frequency of trades in recent years has exceeded regulators' capacity to reconstruct trading events when malfeasance is alleged; therefore, those traders engaging in a high level of activity should have extra reporting burdens.
But in an industry with so many intertwined allegiances among brokers, execution venues, institutional traders, hedge funds and individual investors, the proposed rule is seen as having wide-ranging implications. In general, the industry supports the intent of the rule but is concerned about the burdens of developing a Large Trader Reporting System, or LTRS, from scratch.
To begin with, there is the added cost. To enforce the rule, the SEC proposes creating an LTRS with an enhancement to the existing Electronic Blue Sheets (EBS) system. Blue sheets are electronic questionnaires that require broker-dealers and clearing firms, at the request of the SEC, to supply data about their trading histories that is transmitted from the firm via the Securities Industry Automation Corp. (SIAC) network to the SEC's mainframe for analysis. The LTRS would enable this process, which now takes 10 business days, to happen in real time and would add several new fields to the EBS.
The price tag: $31.8 million in start-up costs, with an estimated ongoing cost of $16.2 million to operate annually. About 300 broker-dealers and clearing firms that currently use the EBS would be affected directly, but it's well understood that one way or another, the cost would be passed on to their customers in the form of fees.
Of course, this is a mere drop in the bucket compared to another recently proposed reporting mechanism, the Consolidated Audit Trail (CAT), which is fathomed to cost between $3 billion and $4 billion to start plus an additional $2 billion annually to operate. The industry consensus seems to be that if the LTRS and CAT are to proceed, at the very least they should be combined to avoid redundancies.
In a 21-page letter to SEC Secretary Elizabeth M. Murray, the Securities Industry and Financial Markets Association (SIFMA), the securities dealers' main trade group, proposed several adjustments to the rule that underscore the patchwork of regulatory systems that currently exists. For starters, SIFMA recommended that the CAT and LTRS be combined, or at least reconciled. Currently the LTRS has an earlier planned implementation date than the CAT and would be subsumed by CAT once that system is implemented.
OATS Should Feed the CAT
Rather than use the EBS, which is a back-office, post-trade system not designed for intraday reporting, and which would require the propagation of new data fields throughout a broker-dealer's trading infrastructure, SIFMA also proposes that the baseline be established using the FINRA (Financial Industry Regulatory Authority) Order Audit Trail System (OATS) already in existence. OATS is a front-office system that records transaction information for all Nasdaq-listed and over-the-counter securities and reports them on a next-day basis. OATS would need to be expanded to include New York Stock Exchange and all other National Market System (NMS)-listed securities, but doing so would cost the industry less and better serve the goals of both the CAT and LTRS, SIFMA's letter argues. Building an entirely new system for essentially the same purpose would be hugely wasteful, industry players say.
"Everyone in the industry believes CAT and LTRS will be combined," says a broker-dealer technology and operations executive who spoke on the condition of anonymity. "When we saw the CAT proposal, we said, 'This could be a monster nightmare.' But we figured that if we work with regulators, we could probably do ourselves a huge favor and replace that patchwork of old stuff and create one trail, based off of an enhanced version of OATS. And if we can, then really it is a win for everyone."
From this executive's standpoint, augmenting OATS is largely a matter of purchasing hardware and adding fields rather than reprogramming - a relatively small one-time cost of "tens of millions" to the industry, with far greater efficiency than the phased implementation of the LTRS and then CAT, as currently proposed.
Regardless, large trading-services and clearing firms, which process transactions and manage post-trade activity for other brokers and their institutional customers, will be significantly impacted by any of the versions proposed. "We have not calculated an impact to the bottom line, but we share the industry's view that the costs in the current proposal are underestimated," says Jesse Lawrence, director and managing counsel at Pershing Trading Services in Jersey City, N.J. "There are definite, significant impacts that would create resource constraints. Implementing LTRS would create additional regulatory burdens."
Pershing generally concurs with the views expressed by SIFMA and the Financial Information Forum (FIF) in their comment letters sent to the SEC, according to Lawrence. The FIF, he says, illustrated that it is often not possible to service information requests overnight, as most brokers extract EBS data from core books and records in a nightly batch operation. A request that arrives during or after the nightly batch's creation would not be serviced.