The US Securities and Exchange Commission (SEC) has an urgent need for a Consolidated Audit Trail (CAT), Commissioner Kara M. Stein said in a recent speech.
The Commission has been trying to build a CAT system, which would be one of the largest databases in the world, to comprehensively track markets across various venues and systems, providing increased transparency and better access to critical data.
Once built, the system would track every stock quote, order, and trade, including the time and location of transactions, the handling broker information, as well as the customers they represent. It will pull data from US public stock and options exchanges, as well as private trading venues known as dark pools.
Dark pools were originally created to help institutional investors trade large blocks of securities at the best possible price, away from public eye. According to Commissioner Stein, studies have shown that the average trade at these private exchanges is for less than 200 shares.
Dark pools have been around for decades, but have recently grown in market share, according to a speech from SEC Commissioner Luis A. Aguilar.
in 2005, the NYSE accounted for approximately 80% of the consolidated share volume of listed stocks, compared to less than 24% today. In addition, there were only a handful of NYSE-like brick-and-mortar securities exchanges then, now there are 18 national securities exchanges and approximately 40 to 50 dark pools.
According to Commissioner Stein, “nearly twenty percent of securities trading now occurs on dark venues.” She also gave a reason why they are attracting a growing proportion of the market, institutional investors are “concerned about information leakage and the impact on price from placing their orders.”
New technology is the another reason that more trades are moving away from public exchanges towards Alternative Trading Systems (ATS), including dark pools. Commissioner Stein has observed virtual locations increasingly replacing traditional, physical locations.
“All across the capital markets, technology and innovation are challenging the old ways of transacting business and old ways of thinking about regulation.”
— – Kara M. Stein, SEC Commissioner
This corroborates Commissioner Aguilar’s observations, dark pool trades are mostly through automatic, electronic networks.
The increased volume of trade through dark venues is a challenge for the Commission, since they have “restricted access and limited reporting.” New innovations and technologies are creating a fragmented trading environment, so the need for a CAT like system is growing.
Although there is a clear and rising need, Stein revealed that the systems construction has yet to begin, despite personally advocating for it over the past two years. “Counting internal deliberations, nearly six years have been spent choosing someone to build the CAT,” she conveyed, citing that a project of this magnitude should have a dedicated team.
“The SEC has largely outsourced its responsibility. This has not worked.”
— – Commissioner Stein
Not only will a CAT help with regulating dark venues, but added transparency will play a significant role in modernising capital markets. Reiterating this point, Commissioner Stein stated that “more execution and order data needs to be available for public consumption,” and market participants should be able to see quotes and order flow. "Transparency is not just about disclosure. It’s also about verification," she added.
“It is clear that opacity does the opposite, and actually favors the interests of certain market participants over others.”
— – Commissioner Stein
As a transparency and CAT advocate, it is no surprise that in her speech earlier this week, at Harvard Law School, Stein stated that blockchain technology has the potential to help. Realizing that the trend is moving away from traditional structures, Commissioner Stein urges the SEC and market participants to work together “to surf this wave of innovation, rather than being overcome by it.”
Robo advisors, online peer to peer lending, equity crowdfunding, and blockchain technology are examples of disruptive technologies named by the Commissioner. Her goal is to ensure that the U.S. Capital market continues to thrive, and maintain quality “in the face of disruption.”
While clearly stating that she was not advocating the adoption or effectiveness of blockchain technology, Commissioner Stein said that the disruptive technology has many potential benefits to the financial industry.
“One can imagine a world in which securities lending, repo, and margin financing are all traceable through blockchain’s transparent and open approach to tracking transactions. That could revolutionize regulators’ approach to monitoring systemic risk in these areas, including the oversight of collateral reuse, to name just one potential use.”
— – Commissioner Stein
In line with the SEC’s mission to “protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation,” Commissioner Stein encourages any exploration into how the blockchain can help raise market quality, citing a number of possible ways as examples.
“I do think regulators, academics, and market participants in the U.S. need to be constantly evaluating potentially disruptive ideas like blockchain. Can it be used to enhance the quality of our markets and investor protection? Or, is there a way it could be used to monopolize markets or undermine competition? How should this technology be best deployed? Should it be run via a public-private partnership, somewhat like the Internet? If the market begins to move toward blockchain technology, regulators need to be in a position to lead, harnessing its benefits and responding quickly to potential weaknesses.”
— – Commissioner Stein
While the Commissioner is not assuming that the market will move towards blockchain technology, she wants to ensure that regulators will be well-positioned to lead the market, should it occur. “Technology is breaking down jurisdictional borders and altering old business models. Digital disruption and the new dominance of data are here to stay. And we in the financial regulatory community need to evolve.”
Access to critical data is another state’s problem the Commission faces. In March, Commissioner Aguilar raised the issue of high-quality information, as markets growsmore complex and fragmented, the Commission’s need for data is even more acute.
Aguilar used the devastating Flash Crash in May 2010 as an example of how important accurate and timely data is, especially for the SEC. Although the Crash was only 20 minutes long, US$1 trillion evaporated, before a partial recovery. According to Commissioner Aguilar, it took the staff at both the SEC and US Commodity Futures Trading Commission (CFTC) over four months to collect and analyze data pertaining to the event.
“No one can doubt that effective oversight of the capital markets requires that the SEC be well-informed. However, one of the most difficult challenges facing the SEC today is the lack of information, particularly at a time when the capital markets’ reliance on the newest and most advanced technology to generate and process information keeps increasing exponentially.”
— – Luis A. Aguilar, SEC Commissioner
This “lack of access to critical data,” is interfering with the Commission’s responsibilities, overseeing enforcement, corporate disclosures, and the asset management industry. Commissioner Aguilar explained that he hopes a CAT will be created and implemented soon.
The blockchain’s default properties of immutability and decentralized access can potentially improve access and accountability to the SEC’s audit trail in a major way. While Commissioner Stein is not predicting that blockchain adoption will happen, in a recent report by TABB Research, analyst Shagun Bali claims that “the adoption of blockchain across capital markets is now seen as a matter of “when, and not if.” Bali also expects to see the number of use cases to increase, alongside the need for regulatory frameworks.
“Further due diligence for defining industry standards with regards to settlement, counterparty and other transactional risks involved are critical. As blockchain gains greater mainstream adoption, a strong regulatory framework will be necessary to maintain a balance between security and future mass-market blockchain scalability, a critical industry challenge that lies ahead.”
— – Shagun Bali, TABB Research Analyst
Many financial institutions have taken an approach that is similar to the SEC, in the case of blockchain mass adoption, they want to get ahead of the game.
“If you embrace disruption, the opportunities are greater than the threats. The companies that will be at risk will be those that resist it.”
— – Jim Moffatt, Deloitte Global Consulting Business Managing Director
As time goes on, more financial institutions and companies are investigating blockchain technology to improve their current business processes. Nasdaq have been experimenting with blockchain technology for their own use, UBS and Barclays have their own blockchain labs to study the technology, and 25 major banks have joined the R3 CEV consortium to the same end.
If past experience is any indication, the SEC is unlikely to be ahead of the game. While for-profit companies have their own dedicated teams and labs to study new disruptive technologies, the SEC has outsourced the responsibilities, clearly delaying any progress.
Nonetheless, being a regulatory body, the SEC has more need for consolidated data than anyone else, especially when unfortunate events such as a Flash Crash occurs, and people will look to them for answers.