Getting the Really Big Picture

Ever since the credit crunch began in 2008, the cash equities markets have been skating along and taking umbrage to the new market structure reforms floated by the US Securities and Exchange Commission (SEC).

Last month, during its board of governors meeting, the Security Traders Association (STA), a US-based advocacy organization for securities traders, responded to an earlier issued concept release delivered by the SEC regarding the US market structure, declaring that there were no signs of “significant deficiencies.”

However, the association did call for the establishment of a national market surveillance system that would link and integrate the existing surveillance systems of individual exchanges and trading venues to provide a holistic view of the market. 

If such a platform had been in place during the sudden near-1,000-point intra-day drop in the Dow Jones Industrial Average (DJIA) index on May 6, tracking down the cause of the fall would have been much easier for regulators and exchanges. 

Whether it was the alignment of the planets, a fat-finger mistake or too many volatility-driven trading strategies feeding off each other, the regulators will not let this go, and the cost to the industry will extend far beyond an afternoon of broken trades.

First, the regulators will want better synchronization among the markets to ensure that investigating these sorts of issues in the future is easier. 

But the challenge is how self-regulatory organizations (SROs) and the SEC will go about delivering it. There are two possibilities. First, they could take an aggregated approach whereby each SRO maintains its own existing surveillance platform and feeds data into a central system that transforms the data into a standard format. This would be relatively easy for the SROs, but I don’t envy the organization that would need to pull in that amount of data, transform it and clean it. Also, the amount of latency introduced by these processes—as well as the physical distance between the various SROs’ matching engines—would have a detrimental effect on its overall usefulness as a real-time system.

The second option is to avoid a middleware-dependent strategy by having all exchanges standardize their surveillance systems and pipe the data into a central store. Considering how each SRO’s surveillance system matching engine operates, this is not a viable solution.

Impractical

Neither strategy seems to be a practical solution. Making a national market surveillance system work would involve making sure that it could keep pace with the various local matching engines that it monitors, or making the matching engines keep pace with the speed and capacity of the central monitoring system. It is doubtful that the former would work because of latency issues and the latter would involve stepping down the performance of the various matching engines to meet those issues. Nevertheless, slow markets are inefficient markets and the SEC doesn’t really want to be responsible for giving arbitrage traders another situation they would be able to exploit.

While the European Commission (EC) is preparing to draft the second version of its Markets in Financial Instruments Directive (MiFID II), maybe it is time for the SEC to revisit Regulation NMS and focus on market synchronization issues. 

The industry has the right to be nervous when the SEC starts dictating technology after the introduction of the Intermarket Trading System (ITS) in 1978, which should stay dead and buried. Instead, the SEC should take a more principles-based approach that would allow each SRO to implement its own technology to meet a pre-defined standard.