Regulatory Systems: Will Their Steep Cost Outweigh Any Benefits?

Wall Street is evolving, seeking to reinvent itself following the financial crisis. Apparently, the metamorphosis will include building information systems that provide transparency into hidden balance sheets and create audit trails of high-frequency trading activity - at a cost of billions of dollars.

Based on the idea that regulators lacked the tools to probe risky trading activity and were blind-sided by the crisis, the SEC has proposed several new rules and systems intended to track trades and positions that are executed through brokers, clearing firms, exchanges, ECNs and dark pools, including the advent of a Large Trader Reporting System and the Continuous Audit Trail, or CAT. (For more on these proposals, see, "The Heavy Burden of LTRS," page 20.) And with the panic over brokers offering clients unfiltered, or "naked," access to execution venues, the Market Access Rule (Rule 15C3-15) was introduced to force brokers to rein in sponsored access with mandatory pre-trade risk controls.

But could these proposals do more harm than good? Will they overwhelm the securities industry, forcing brokers to spend billions of dollars over the next three years? And will these ambitious projects come soon enough?

More than a few trading technology experts feel that the SEC - which is asking the nine Reg NMS market centers and FINRA to form a consortium and contract with an outside entity to build the CAT - is taking the wrong approach to developing the technology.

For example, in a letter to the SEC, FTEN, a provider of high-speed execution systems and risk monitoring technology, warned that undertaking a mammoth "greenfield" project will undermine the industry's nascent economic recovery. While the entire brokerage industry earns about $12 billion in commissions per year, FTEN general counsel Gary LaFever pointed out that if you add up the costs of these regulatory systems, "You're at $6.75 billion, which is more than half of what the industry makes in gross commissions."

In a follow up interview, LaFever tells Advanced Trading, "There's got to be a more effective and efficient way to do this. The approach to just throw money at it would literally kill the industry."

In its comment letter, FTEN contends that existing commercial vendors could accomplish the same goals without starting from scratch. Pointing to its own secure data cloud technology, FTEN says it already captures and consolidates this data for more than 50 market centers and 1,400 market participant IDs (MPIDs). FTEN CEO Ted Myerson estimates that the firm covers 25 percent to 35 percent of the processing in the U.S. equities markets. And FTEN insists that it could easily use its technology to capture the rest of the market.

The tech firm has put forth a four-phase plan that would use its technology to address all of the proposed systems at once. "We believe you can take the Consolidated Audit Trail, the Large Trader Reporting Rule and the Market Access Rule and take one shot at it," LaFever contends. "And you can roll it out in 30 days."

But beyond the fears over cost, IT resource drains and duplicative systems, there is a lack of confidence among market participants in the SEC's ability to manage the voluminous amount of data they are requesting from brokers and trading firms. There also are fears about information leakage of proprietary trade data.

Nonetheless, the industry generally agrees that the markets need better surveillance systems to protect against systemic risk, so there is support for these systems. At SIFMA's annual technology conference in June, one panelist stressed that regulators need to improve oversight, particularly of high-frequency trading, in order to restore investor confidence.

"Electronic market participants are turning over trades at a high frequency - the SEC is trying to get its head around [the trading activity]," the executive said. "With this kind of information at its disposal, the SEC could learn who the bad guys are and reconstruct the market."

Industry participants on the SIFMA panel also felt that some of the industry's legacy systems, such as FINRA's OATS and Nasdaq's ACT, could be consolidated into CAT.

But with an estimated cost for the CAT system of $4 billion in Year One and another $2.1 billion a year until the system is complete, the SEC is bound to receive push-back. Perhaps the regulator would do well to at least listen to innovators such as FTEN, which already are tracking the markets at millisecond speeds. n

Ivy is Editor-at-Large for Advanced Trading and Wall Street & Technology. Ivy is responsible for writing in-depth feature articles, daily blogs and news articles with a focus on automated trading in the capital markets. As an industry expert, Ivy has reported on a myriad ... View Full Bio