With technical malfunctions occurring more frequently in US equity and options trading venues as well as consolidated data feeds, regulators are counting on a new set of laws to boost the resiliency of critical systems and curb the number of market disruptions.
Last March, the Securities and Exchange Commission proposed Regulation System Compliance and Integrity, known as Reg SCI, to mandate a set of procedures and standards that would require firms to boost the resiliency of their systems and comply with standards to maintain fair and orderly markets. Reg SCI will formalize and make mandatory the SEC's current Automation Review Policy, which as been developed over the past two decades.
After a series of technological malfunctions, including the flash crash of May 2010, Facebook's IPO in May 2012, and Knight Capital's trading loss of $460 million in August 2012, the SEC saw the need for a mandatory regulation as the outages and breakdowns were eroding investors' confidence.
On March 7, the SEC unanimously approved Reg SCI to mandate compliance with standards for testing and business continuity, and to provide notifications of system events or disruptions when they occur.
However, since Reg SCI's comment period ended in July, there has been a new round of technical glitches. On Aug. 22, Nasdaq's consolidated securities information processor (SIP) had an outage that forced the market operator to shut down trading in 2,700 listed companies for several hours. Two days earlier, Goldman Sachs had an order-routing glitch that sent erroneous options orders. On Sept. 16, US options trading was halted because of an outage with the Options Price Reporting Authority feed.
These market-wide disruptions have prompted concerns about the fragility of the securities market infrastructure and the complexity of networked exchanges and dark pools interacting at high speeds. "I think it's accepted and understood that the industry needs to have a real debate on what it needs to do to clean up its outward perception," said Jeffrey Wallis, managing partner of SunGard Consulting Services, in an interview.
The flash crash was caused by an algorithm that did not perform correctly. Since that occurred at the broker level, Reg SCI, in its current form, would not have covered that." -- Howard Meyerson, Liquidnet
But there has been industry pushback on the regulation. Despite the acceptance of a need for increased resiliency and procedures to safeguard against operational risk, there is debate about whether Reg SCI in its current format can stop the market glitches. Some think the regulation is too broad and detailed and that the SEC is underestimating what it will cost. Others argue that it covers brokers that operate alternative trading systems or dark pools but doesn't cover brokers that match orders internally with a system that isn't an ATS.
"Overall, Reg SCI is a positive development to the extent that market participants are required to have greater controls to protect against market disruption," said Howard Meyerson, general counsel at Liquidnet, operator of a global ATS for institutions, in an interview. "These market disruptions can adversely impact investor confidence in the market, which is why we support Reg SCI," adds Meyerson. However, Liquidnet, which operates the largest buy-side-only institutional marketplace, contends that Reg SCI is too narrow and should apply to all trading platforms.
"If you think about it, the flash crash was caused by an algorithm that did not perform correctly. Since that occurred at the broker level, Reg SCI, in its current form, would not have covered that," Meyerson says. Liquidnet would like to see a broader rule that covers all market participants across the industry.
Even though Reg SCI covers ATSes, a very large broker-dealer could still cause a significant outage without being an ATS operator, says Sudhanshu Arya, managing director and head of technology for electronic brokerage at ITG, an operator of algorithmic trading and ATSes. For instance, there could be an automated trading system coming out of a brokerage firm that triggers an outage or market-wide problem, he warns.
However, electronic trading experts argue that they know their internal systems better than the regulators and are wary of overregulation and its additional compliance costs.
"The systems are extremely complex. We maintain the people and technology that are closest to a given product in the firm are most qualified to identify what the caveats are," says Arya, adding that brokers know "the holes" in their own systems and are prepared to deal with external outages. "We are one of the very few dark pools that actually detected those bad quotes and stopped trading ahead of Nasdaq announcing there was a SIP issue."
While Arya agrees the SEC has a role to play in requiring firms to provide periodic reviews of their technologies and their outages, he doesn't think the agency should prescribe how development and testing ought to be done. Instead, he suggests the SEC should demand that firms adhere to levels of service and monitor firms in terms of outages. "Let's not have the pendulum swing too far."