Rob Swystun, Pristine Advisers
Although the US Securities and Exchange Commission is tasked with regulating all the stock market trading in the US, it actually can’t “see” all the trading that happens.
In fact, over 30% of the trading that happens in the country cannot be tracked by the SEC because it happens in dark pools or inside large wholesale brokerages that match buy and sell orders internally, according to an article by Matthew Philips and Silla Brush for Bloomberg Businessweek.
The fact that the organization tasked with regulating trading in the country can’t even see well over a quarter of that trading is a staggering oversight that the SEC is set to address … eventually.
But first it needs a tool that will allow it to see into these dark pools, which operate with exactly zero transparency. That tool is a proposed supercomputer called the Consolidated Audit Trail (adorably acronymed as CAT, which you just know was done on purpose).
The CAT will be one of the largest databases in the world, archiving 50 billion daily transactions that includes not only every stock quote, order and trade, but when they happen, who handled them and the customers represented. It will finally give the SEC the much-needed complete view of the investing markets in the US, pulling data from not only the 18 public stock and options exchanges, but — more importantly — the private, bank-run trading venues that don’t have to immediately report data to the SEC, the aforementioned dark pools.
And not only will it enable the SEC to finally see what is going on in these dark pools of trading, it will enable it to detect suspicious patterns that might indicate insider trading and, as Phillips and Brusch point out, it will answer the question of whether the stock markets are rigged in favor of high speed traders, who can influence the markets in drastic ways before people have time to react.
“That’s exactly why the SEC wants the CAT,” says Craig Lewis, a Vanderbilt University finance professor who stepped down as the SEC’s chief economist in May. “It’s great that it will let you monitor potential insider trading, but I view that as a second-order benefit to conducting market research designed to inform future rule making.”
So, the CAT will be extremely useful and is absolutely necessary for the SEC to do its job the way its supposed to do it. The only thing is, the CAT’s creation is moving at the pace of an entirely different animal: a turtle.
Although the SEC approved the creation of the CAT two years ago, it still doesn’t know who will build it and how much it will cost, two rather important aspects of any project.
The SEC isn’t actually the organization that’s handling the building of the CAT, either. It handed that responsibility to the public financial exchanges and the Financial Industry Regulatory Authority (Finra), a private nonprofit that is funded with fees from the exchanges and the Wall Street brokerages it regulates. Finra will create and run the CAT along with the market exchanges.
However, handing the creation of the CAT over to players within the industry that it is supposed to help regulate is seen by some as a bit of a foolish move, taking power out of the SEC’s hands, which has already manifested in the aforementioned turtle-like speed with which the CAT is progressing.
“The CAT is moving like a glacier for a reason,” president of Better Markets (and preferer of ice-related similes) Dennis Kelleher said. “It’s not exactly in their interest to be quick about this.”
Better Markets is a nonprofit promoting tighter regulation of the markets.
It’s not exactly clear at this point who will pay for the system, but brokers — who certainly will be one group that helps pay for it — want the market exchanges to also help pay for the system. Representatives from Finra and the market exchanges are set to outline their plan of financing the CAT and securing its data to the SEC at the end of September. Once the SEC approves the funding model, a winning bid will be chosen to create the CAT, which is expected to be fully operational in 2018.
Among the bidders are Google teamed with SunGard; Hewlett-Packard teamed with Booz Allen Hamilton; IBM (no longer in the running); Promontory Financial Group teamed with Tata Group (no longer in the running); and, just to throw another little monkey wrench into things, Finra itself has placed a bid. While on paper this seems like a conflict of interest, seeing as how Finra is in charge of awarding the contract, the nonprofit says that it has kept the employees assigned to work on its bid separate from the employees who are helping to award the contract.
Phillips and Busch say that while bids are secret, a couple of people who are familiar with the process have claimed that they range from $170 million to $1 billion to create the CAT and run it for five years.
Reaction to the CAT’s imminent arrival has been positive, particularly from the high frequency traders who play in the dark pools that the system is set to make transparent.
“The CAT will separate the bulk of speed traders from a handful of bad actors who practice manipulative strategies,” said Peter Nabicht, a senior adviser at the Modern Markets Initiative, a high-frequency trade group. “I think the data will ultimately exonerate us in the minds of a lot of people.”
Whether or not that happens remains to be seen … eventually.