We have long been a proponent of a Consolidated Audit Trail (CAT).  But when the SEC first proposed the CAT  on May 26, 2010, just 20 days after the Flash Crash, we never imagined it would take them over two years to approve their proposal.  Finally on Wednesday, with a vote of 3-2, the SEC approved the CAT.   But what exactly did they approve??

According to their press release , “The new rule adopted by the Commission requires the exchanges and FINRA to jointly submit a comprehensive plan detailing how they would develop, implement, and maintain a consolidated audit trail that must collect and accurately identify every order, cancellation, modification, and trade execution for all exchange-listed equities and equity options across all U.S. markets.”

Sounds pretty good, right?  Well, not exactly.  Apparently, during the two years that the CAT proposal sat around, some industry participants made their voices known and were able to water down the original proposal.  We are not talking about the switch from a proposed $4 billion dynamic audit trail to a delayed audit trail.  We are talking about the easing of customer identification tags.  In the original May 26, 2010 proposal, the SEC stated:

“The Commission is concerned that certain information about orders and executions that would be useful to efficient and effective regulation of inter-market trading activity and prevention of manipulative practices is not captured by existing audit trails. Most importantly, the existing audit trails do not require members to provide information identifying the customer submitting an order, the person with investment discretion for the order, or the beneficial owner. The identity of this “ultimate customer,” however, often is necessary to tie together potential manipulative activity that occurs across markets and through multiple accounts at various broker-dealers…The Commission preliminarily believes that gaps such as this in required audit trail information may hinder the ability of regulatory authorities to enforce compliance with SRO rules and the federal securities laws, rules, and regulations in a timely manner.”

The May 26, 2010 proposed rule also stated: “The proposed Rule specifically would require, for the receipt or origination of each order, information to be reported to the central repository with respect to the customer that generates the order — specifically, the beneficial owner(s) of the account originating the order and the person exercising investment discretion for the account originating the order, if different from the beneficial owner….The proposed Rule also would require a unique customer identifier for each customer. The unique customer identifier should remain constant for each customer, and have the same format, across all broker-dealers. This unique customer identifier would serve a similar purpose to a customer’s social security number or tax identification number.”

Two years ago, it seemed that the SEC was adamant about requiring an end user customer tag.  They said it would be necessary to identify manipulative activity.  But something happened and the newly approved version of the CAT will only:

“Requires each broker dealer and national exchange to be assigned a unique, cross-market identifier to be reported to the central repository along with every reportable event.”

“Requires each customer as well as any customer adviser who has trading discretion over a customer’s account to be assigned a unique, cross-market customer identifier to be reported to the central repository for every order originated. “

Read the above two requirements very carefully and note the differences between order origination and EVERY reportable event.  Two SEC Commissioners dissented and did not vote for the CAT.  One of them, Commissioner Walters was very vocal in her opposition and keyed in on the fact that the CAT would not have stringent customer id requirements:

“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.”

Why is this so important?  Because many HFT’s are not brokers and go through a sponsored access broker.  Essentially, they would still be masking their activities underneath their sponsoring brokers shield.  Things like wash trades, for example, will be very difficult to identify under the newly approved audit trail.

We would urge the SEC to reconsider this and heed Commissioner Walter’s warnings.  The last time we saw this type of dissent from SEC Commissioners was when Reg NMS was approved in 2005.  Then, Commissioners Glassman and Atkins dissented and said this:

“…Regulation NMS is at odds with Congress’ goal, expressed in the Securities Acts Amendments of 1975 (“1975 Act Amendments”), of protecting competition within the national market system. We believe that Regulation NMS turns back Commission policy regarding competition and innovation and sets up roadblocks for our markets.  The majority’s statutory interpretations and policy changes are arbitrary, unreasonable and anticompetitive…Regulation NMS saddles the marketplace with anachronistic regulation that reduces investor choice and raises investor costs.  Far from enhancing competition, we believe that Regulation NMS will have anticompetitive effects.”

As we all know by now, Reg NMS was the straw that broke the markets back.  It fragmented liquidity and created micro second arbitrage opportunities that the HFT’s have been exploiting since its inception in 2007.  The SEC would have been wise to have listened to Commissioners Atkins and Glassman back then.  They would be wise to listen to Commissioner Walters now.