Consolidated Audit Trail Moves Forward

Terry Flanagan

The Securities and Exchange Commission will soon have the ability to monitor transactions in real-time in order to detect potentially disruptive market activity stemming from high-frequency trading.

The SEC has delegated to the Financial Industry Regulatory Authority (Finra) and other self-regulatory organizations the task of creating a consolidated audit trail, or Cat, and has also contracted with Tradeworx, a high-frequency trading firm, to provide real-time information.

Since Cat data will only be available on the day after trade, or T+1, the real-time system by Tradeworx fills in a gap.

“Cat is T+1,” said Dennis Lee, senior manager of capital markets at Deloitte, a business advisory firm. “The SEC had issued an RFP last year for a real-time system and awarded the contract to Tradeworx in July. It’s not clear how this real-time data will work with Cat, but both initiatives are for market surveillance.”

Among other things, the rule requires self-regulatory organizations to jointly submit a plan –called a national market system (NMS) plan– to create, implement and maintain a consolidated audit trail. The rule specifies the type of data to be collected, when the data is to be transmitted and how the data is to be prepared for regulatory use.

“Rule 613 mandates a consolidated audit trail of all Cat-reportable events, including orders, quotes, updates, cancellations—anything that hits the market,” said Lee. “It’s intended to capture everything from order generation to execution. Right now, there’s no way to trace that in its entirety.”

The self-regulatory organizations are expected to pass the costs of building Cat on to the industry.

“Most buy-side firms will expect the sell side to pick up the tab for compliance with rules like market access and the upcoming Cat regulations—and require them to provide auditable proof of compliance,” said Jay Hinton, global product manager at Mantara, a technology provider.

Currently, there is no single database of comprehensive and readily accessible data regarding orders and executions.

Instead, each self-regulatory organization uses its own separate audit trail system to track information relating to orders in its respective markets.

Finra operates the Order Audit Trail System (OATS), an integrated audit trail of order, quote and trade information for Nasdaq and over-the-counter equity securities.

Finra uses this audit trail system to recreate events in the life cycle of orders and more completely monitor the trading practices of member firms, who are required to develop a means for electronically capturing and reporting to OATS specific data elements related to the handling or execution of orders.

The existing audit trail requirements vary significantly among markets, which means that regulators, when conducting a cross-market analysis, must obtain and merge together a large volume of disparate data from different entities.

The SEC adopted Rule 613 to create a comprehensive consolidated audit trail that would allow regulators to efficiently and accurately track all activity throughout the U.S. markets in certain securities known as NMS securities.

The SEC’s newly-created Office of Analytics will use both the data generated by Cat as well as that generated by Tradeworx to perform market surveillance.

“Using the Cat data and the real-time data they get from Tradeworx, this new team will perform the analytics, profiling and analysis of HFTs,” said Lee at Deloitte. “The metrics have yet to be determined.”

The U.S. Commodity Futures Trading Commission is working on its own versions of Cat, dubbed the Order Book, with work beginning earlier this year.

“The CFTC Order Book will do for the commodities and futures markets what Cat does for the equities markets,” said Lee.

Although the CFTC and SEC initiatives are separate, at some point there will need to be linkage so as to provide a view across the entire capital markets.

“The CFTC monitors single stock futures, ETF futures and index futures, where the underlying is equities,” said Lee. “If you truly want cross-market surveillance, you need to be able to look across all markets.”

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