Reporting Market DisruptionsOne of the areas Reg SCI requires is reporting SCI events, including disruptions, compliance issues, and intrusions. "If you look at the requirements to report a systems disruption, it might not be helpful for the SEC to get a report on every single issue that arises," says Liquidnet's Meyerson. "It may be more efficient to receive reports on material problems only so they can better focus on those issues that can have serious impact."
In addition, some of the software development standards in Reg SCI need to be more tailored to the securities industry, says Meyerson. He suggests the SEC form a working group committee of industry participants, vendors, and regulators to come up with appropriate controls that are consistent with development practices in the industry. "While every firm would have their own methodology for developing software, there should be certain elements that are standard to every firm. This would include documenting requirements and testing before software is put into production," he says.
The SEC is reviewing all the comment letters and is expected to come up with a final version for the rule in 2014. The question is, will Reg SCI help stop the market disruptions that have continued to occur?
On a similar note, SunGard's Wallis recommends bringing in experts from other well-known entities, such as Google, Amazon, and Yahoo. Those companies run large advertising exchanges that work all day, every day.
Raising The Bar On TestingSince many of the market disruptions in equities and options are related to software flaws, one of the major areas discussed is testing in a real-time environment. ITG's Arya agrees there is a role for the exchanges in the testing process. "Exchanges should provide a better platform for testing, but I don't think we should … have a mandatory testing on a quarterly basis across the Street," says Arya.
Liquidnet's Meyerson says that testing with customers is typically on a one-to-one basis, based on a customer's request. For instance, institutional customers are not required to test with ATSes. "It should be a customer's choice on what they require to be comfortable," says Meyerson. "Certain industry-wide testing does make sense among regulated entities like broker-dealers that are obligated to participate." Since all the brokers, exchanges, and ATSes are networked, Meyerson says that for testing to work properly, all the participants in the network should be subject to the same standards. That's why he suggests that brokers developing or licensing algos should be included in Reg SCI.
Bloomberg Tradebook, a broker-dealer providing algorithms and ATSes, submitted a comment letter on Reg SCI strongly advocating that SCI entities be required to offer mechanisms such as test facilities and test symbols to their buy-side clients. "After having … numerous conversations with buy-side clients, ... we believe that they share our strongly held view that the establishment of a full set of production testing infrastructure is critical in reducing operational risk in the national market system," wrote Ray Tierney, Tradebook president and CEO, and Gary Stone, chief strategy officer, in a comment letter. Tradebook suggested the SEC work with the FIX Protocol Ltd. standards body, whose FPL Risk Mitigation Symbology Working group could provide the financial community with no-risk test symbology for the production validation of complex trading and portfolio management systems. Under Reg SCI, Tradebook contends that the SEC could mandate the creation of test tickers and require that they be supported by all Reg SCI entities.
While a lot of the Reg SCI discussion concerns testing in a real-time environment, some industry participants point out that testing isn't a panacea. At the SIFMA Market Structure conference in October, Brett Redfearn, head of market structure strategy for the Americas at JP Morgan Chase, pointed out that a firm can test for 8 million scenarios and the one it didn't test for can turn up and expose a latent flaw in the software.
On the same panel, Jamil Nazarali, head of Citadel Execution Services, said that while there is a lot of emphasis on testing and quality assurance, it would be helpful if regulators and the industry spent more time putting in place procedures and risk checks for when something goes wrong. He noted that when the Knight Capital trading debacle, dubbed the "Knightmare on Wall Street," happened, the problem continued for 45 minutes. "If firms have really stringent risk procedures, if they have fuse boxes and kill switches internally, then when something does happen, there will be more control," Nazarali said. "While firms will still have to invest in preventing outages and technical breakdowns, it would be much better to limit the damages."
Minimizing Systems Changes: Good Or Bad Idea?Some commentators objected to giving the SEC 30 days' notice for material systems changes in systems. "The SEC wants you to register that change 30 days in advance," says Wallis of SunGard. "Quite frankly, 30 days is a lifetime when it could be a material change to an algorithm or a process," says Wallis, who argues that this would have a negative effect on innovation and profits. Furthermore, he says, it encourages firms to stockpile changes to wait for windows when changes can occur, which can increase systemic risk. Rather than reducing the risk of change, Wallis says the focus of Reg SCI should be on "building resiliency into the system of liquidity and trading parties." Firms that introduce change more frequently and incrementally make fewer errors, he says.
The SEC is reviewing all the comment letters and is expected to come up with a final version for the rule in 2014. The question is, will Reg SCI help stop the market disruptions that have continued to occur? "No regulation is going to stave off glitches," SEC Commissioner Dan Gallagher said at the SIFMA Market Structure conference in October, adding, "There's a lot of systems; they fail." Still, he said, his concern is that these system glitches give a perception to the investing public that the market is wild and that their orders aren't being handled properly.
Though Reg SCI will be more work for the industry, Liquidnet's Meyerson still sees it as a step in the right direction. "Overall, it can enhance market confidence. That will be a net positive for all industry participants and customers as well."