The Final Rules for Consolidated Audit Trail

Editor’s Note: Elisse B. Walter is a Commissioner at the U.S. Securities and Exchange Commission. This post is based on Commissioner Walter’s statement at a recent open meeting of the SEC, which is available in full here. The views expressed in the post are those of Commissioner Walter and do not necessarily reflect those of the Securities and Exchange Commission, the other Commissioners, or the Staff. This post relates to the adoption of an SEC rule on consolidated audit trail; the final rule is available here.

I wholeheartedly and unreservedly support the creation of a consolidated audit trail. As someone who has worked at three market regulators for most of her career, I truly appreciate that there is a real need for regulators to have a robust and effective cross-market tracking system that will provide order and trading information in a timely, accurate and consistent manner.

The SEC regulates the largest capital markets in the world, and I am confident that a properly constructed audit trail will arm the Commission with needed information that we –perhaps shockingly– have not had in the past. Among other things, a consolidated audit trail will enable the agency and other regulators to reconstruct trading to determine if the market has been manipulated or if other rules have been broken. It would thus greatly enhance and expedite our examination and enforcement efforts. And, its benefits would inure to our policy efforts as well. For example, a sound, robust consolidated audit trail will enhance our speed and accuracy in determining the cause of significant market events like the May 6th flash crash. These enhanced capabilities will in turn serve to improve our policy responses and restore investor confidence to our markets.

Following the flash crash, the investing public was astonished to learn that the SEC did not have direct or timely access to all the data necessary to monitor and surveil the market, but rather had to depend on other regulators and market participants for the most basic market data. And, that information was piecemeal and required all-too-slow consolidation in order to reconstruct the day’s events.

And so it is my view that the establishment of a consolidated audit trail is one of the most important tasks facing the Commission, and I firmly support building a strong and rigorous system that values accuracy, efficiency, and timeliness. I also believe that the system should grow to encompass other products, which is particularly important in today’s marketplace where strategies frequently combine trading in a number of different types of instruments, and that, to avoid the cost and disruption caused by system rebuilds, the system should also be designed to evolve along with advancements in financial products and technology.

The rule before us today is a move in the right direction, since it could create the foundation of a consolidated order tracking system giving regulators more data elements than presently available. It also could provide other significant benefits, including the consolidation of order and trade information in NMS securities across all markets in one system, a uniform method of identification of orders and account holders, and a potential reduction in duplicative systems and the elimination of archaic ones.

However, although the rule before us today presents a positive step forward, I must respectfully dissent from its adoption.

While I continue to believe that the perfect should not be the enemy of the good, sometimes the good just isn’t good enough. I really believe that this is a moment in which the Commission should be taking decisive steps to ensure that America’s capital markets remain the world leader in fairness, capital formation and regulatory innovation. This is a moment when we should be guiding the SROs to leverage existing technology to create an efficient and effective source of market data that will serve regulators and the marketplace well today and for decades to come. Instead, we appear to be adopting an overly cautious approach.

I speak drawing upon my observations over the course of my career as a securities regulator and everything I have witnessed in the marketplace over the past four years during my service as an SEC Commissioner. I believe that the rule before us today falls far short of where we need to be in terms of bringing market oversight into the 21st century.

Considering that it has taken the agency three years to get to this adopting stage, and it will likely take several more years before any consolidated audit trail system is finally in place, the rule we consider today is disappointingly weak. As the release points out, the ultimate effectiveness of core SRO and Commission regulatory efforts depends on the accuracy, completeness, accessibility, and timeliness of audit trail data. Yet, the rule fails to set meaningful minimum requirements to assure that these important goals are achieved. Instead, the rule has been altered to be less prescriptive and hence less directional.

For example, the adopting release eliminates the requirement to report orders with a unique order identifier throughout the order’s entire life cycle with a more general requirement that the repository be able to link together all life cycle events for the same order. Further, the rule replaces the use of unique customer identifiers, which could enhance the ability of regulators to reliably and efficiently identify the beneficial owner of the account originating an order, with a less effective identification of the account holder—which, in some cases, would only reveal the entity named on the account rather than the actual individuals controlling it. In short, the rule’s flexibility may well result in less timely, complete and accurate information and therefore less effective market oversight.

The rule simply requires that the SROs’ plan take into account certain “considerations,” such as the source of data that will be reported to the central repository, the time in which data would be made available to regulators, the accuracy and reliability of the data reported, and the flexibility and scalability of the system. In my view, the Commission should be setting specific parameters for each of these items. Instead, the rule’s only direction is that the SROs provide a discussion of how the NMS plan would address them. Likewise, while the “use cases” in the release aim to provide details about how the Commission envisions regulators would use, access, and analyze the data, to me, they are, for the most part, more akin to a solicitation of SRO responses to various broad, open-ended questions. As a result, the rule fails to provide any certainty that the system will provide accurate and timely data in an effective manner, which is critical to the Commission’s ability to discharge its responsibilities to protect investors and maintain fair, orderly, and efficient markets.

It is striking that, in marked contrast to the increased flexibility built into the rule to allow for a broader set of solutions, the rule contains an absolute prohibition on the NMS plan from mandating reporting audit trail data prior to 8 a.m. on the next trading day. I fail to understand the rationale behind this restriction, which essentially precludes the SROs from taking advantage of current and potential technological advancements that could provide more timely, more complete, and more accurate information. Indeed, one of the most important things we learned from the comment process was the potential for “drop copy” technology to produce a consolidated audit trail that not only is more timely and accurate than one based on existing audit trail technologies, but also could be constructed at a relatively low cost—in other words, a solution that might really be “better, cheaper, faster.” Significantly, due to the bounded 8 a.m. limitation, the rule not only fails to require the SROs to explore this alternative in good faith, but bars them from submitting an NMS plan that takes full advantage of “drop copy” technology, even if it is the best solution.

In addition, the Commission has elected to take an unprecedented multi-step approach to the economic analysis of this rule–a process that is normally completed when the Commission adopts a rule. Today, the real economic analysis is being deferred until after the NMS plan is submitted. This approach unfortunately postpones any real commitment by the Commission to adopt any of the plan features until a full cost-benefit analysis is completed. This essentially means that each of the remaining minimum requirements for the NMS plan–even the unique account and order identifiers–could be at risk. In other words, the Commission is not yet prepared to commit that any particular aspect of a consolidated audit trail is economically justified.

My concern is that the release sets the stage for an uphill battle to reach a robust and effective consolidated audit trail system. With few if any firm standards to be met by the SROs, I fear that today’s rule could lead to the path of least resistance and one that may only lead to incremental improvements using the existing OATS infrastructure, a system that was built more than a decade ago without the benefit of subsequent technological advances.

We seem to be placing the entire burden on the SROs to improve their audit trails without providing sufficient guidance. Yet, history teaches us that this type of advance is not frequently undertaken voluntarily. In fact, many existing SRO audit trail systems were created only as a result of Commission enforcement actions and the resulting settlement orders instituted against the SROs for their failure to adequately surveil their markets.

I hope that the SROs and the industry will understand from my vote against the rule before us today that this Commissioner will not be satisfied with merely incremental changes; we need far more.

Although I feel compelled to vote against the Staff’s recommendation, it is my hope that the SROs will go above and beyond the minimum required by the rule. As they are developing the terms of the NMS plan, I ask that the SROs focus on the long term potential of the consolidated audit trail system for the quality of our markets. I do not want the SROs to be confined to the easy thinking that the system should necessarily be based on existing audit trail systems that were built well over a decade ago. As the philosopher, Francis Bacon, once said, “He that will not apply new remedies must expect new evils; for time is the greatest innovator.”

Rather than going for the minimally acceptable approach, I strongly encourage the SROs to be open to the use of new, innovative technology, which may be more efficient and more effective than that in use today. Of course, the cost effectiveness of plan features and the manner in which they could be achieved should be determined and considered as the rule requires. But, it may well be that innovative solutions will be the most cost-effective.

I would also like to see the SROs explore the possibility of reporting more granular and detailed customer information. For example, identification of the individuals behind a trading firm that may be the account holder would be a significant improvement. Knowing who is behind each order and trade could significantly help regulators detect and respond to manipulative patterns of trading across multiple market centers more quickly and readily. In fact, the release acknowledges that without unique customer identifiers, many of the benefits of a consolidated audit trail would not be achievable.

Another area worthy of further consideration is in the level of accuracy of the data reported and the speed with which that accuracy is achieved. It goes without saying that data is not useful unless it is accurate.

Similarly, more could be done with respect to the time when the data is reported. Trading is presently done in real time, and certain SROs monitor their own markets in real time, so it seems reasonable to consider more prompt regulatory reporting. Contemporaneous drop copy submission could be a viable possibility and one that may not add significant cost to the system, particularly given its potential accuracy advantages (and the cost savings they entail). If that proves to be the case, I ask that the SROs request an exemption from the 8 a.m. restriction in the rule in order to include contemporaneous drop copies as an option (or perhaps even a requirement) in the plan. If we are ever to develop the capabilities to monitor and surveil the markets in real time or near real time, regulators eventually must be given the data in such time. Not striving to do so seems to ensure that the industry remains at least one step, or one day, ahead of the regulators.

And finally, in my view, the consolidated audit trail system should be built with a view to eventual expansion to include additional instruments, such as OTC equities, fixed income, and futures. We cannot fully oversee markets with multi-instrument strategies without that capability.

These are some of the things that I will be looking for when I review the NMS plan. My vision is that a comprehensive audit trail will change the way we regulate by dramatically improving our insight and understanding of the market place, reducing our reliance on being told about what happened, and ultimately fostering a more collaborative regulatory regime with the industry and our co-regulators. To me, this is indeed an area where acting in the best interests of investors can and should be in the best interest of the industry and SROs as well.

To be clear, I believe that the will and support among the Commission, and the industry for that matter, to build a consolidated audit trail exists today. But, given the omissions from today’s rule that concern me, we may fail to achieve important advancements and squander the opportunity to build a truly effective system. But I hope that my fears prove to be unfounded and that the SROs vigorously develop an effective, comprehensive system that brings market regulators to the 21st century.

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