Dear chairman Mary Jo White,
As informed by NASDAQ after the August 22 incident, price quotes were not being disseminated by the Securities Information Processor (SIP) for three hours. There was a connectivity issue, which led to degradation in the ability of the SIP to disseminate consolidated quotes and trades. After the cause of the issue, The Flash Freeze, was identified and addressed, trading resumed at 3:25PM. While NASDAQ has promised to work with other exchanges that are members of the SIP to investigate the issues, their time to self-police has passed.
A world of high-frequency trading demands high-frequency regulation and leadership. As I describe in my book Knightmare on Wall Street, Knight Capital had failed on August 1, 2012, in their responsibility to create a ‘fair and orderly’ market as a market-maker firm. That’s what happened with NASDAQ yesterday too. This type of problems severely erodes the public’s confidence in the markets to function smoothly. Without confidence in the operation of the market, the entire financial industry can come very close to grinding to a halt. And this would have severe repercussions on every corner of the economy.
If the world of high-frequency trading is predicated on speed, its regulation must also be built around the same requirement. The aim of financial markets regulation is to create an atmosphere of trust for market participants. If a market participant believes that he or she can’t enter into fair transactions, then that individual will not invest in that market. To create that atmosphere of trust and effectively regulate global financial markets, regulators must be armed with the capacity to analyze trading activity in real-time, which leads me to my first suggestion: let’s arm the SEC with the ultra-modern tools the most sophisticated trading firms are already using.
When considering technology, mistakes are bound to happen. However, exchanges and trading firms are expected to have controls in place and invest in the technology to keep them up to date. Most companies would realize the need of these controls and honestly attempt to implement them, but their IT departments would soon hit a wall, because of a lack a proper budget and other problems. Management constantly scrutinizes technology budgets and sometimes doesn’t want to spend the money on safeguarding their systems. Circuit breakers, kill switches, fuse boxes or any type of failsafe mechanisms always gets cut or delayed, as companies reason accidents would never happen. It is a fallacy, a lunacy, a heresy. It is not the lack of technical capability. It is just that these safeguards do cost money.
That leads me to my second suggestion. If a firm is not going to make a priority spending money to make sure that they are safeguarded and the SEC is not going to mandate it to a level of detail or technical specificity that makes it impossible to duck it, then accidents are going to happen. Only in July 2013, FINRA would send letters to about 10 trading firms asking nine detailed questions about how they used and deployed algorithms; the SRO was asking the trading outfits to disclose whether they used kill switches to halt individual algorithms and under what conditions they would shut off trading. The SEC needs to revamp its recruiting and staffing processes to add top talent to be able to be prescriptive enough with market participants.
Financial firms will be welcome to trade if they acquire a specified level of “insurance” around their capabilities. Firms need to have standards in place that could be thoughtfully audited on a regular basis by the regulators, either the exchanges, SIFMA, the SEC or the CFTC. Unfortunately, there are very few real truthful audits that really go on, as people view them mostly as a huge pain. “Let’s just get this done” is the battle cry. Trading firms would like to minimize regulation overall because it is sometimes challenging and costly. Yet, in some ways, bad business decisions can be prevented by appropriate regulation, as I describe in my first book The Speed Traders. It is a constant push and pull that leads me to my third suggestion, let’s quickly move forward with Regulation Systems Compliance and Integrity (Reg SCI), and expand it to all market participants.
Reg SCI would require exchanges, dark pools, ECNs and clearing firms to comply with requirements regarding their automated systems that support the performance of their regulated activities. However, disruptions have originated not only at exchanges, dark pools, ECNs and clearing firms, but also in the heart of trading firms (Knight Capital, Goldman Sachs, and others), which leads to the question why those were not covered by the proposed regulation. Isn’t it in trading firms’ best interest to provide the same operational assurances requested from exchanges, dark pools, ECNs and clearing firms? While the SEC has leveraged the market access rule to require participants with direct access to have suitable “risk management controls and supervisory procedures reasonably designed to manage the financial, regulatory, and other risks of this business activity,” the additional system safeguards and sanctions proposed by Reg SCI are also relevant for trading firms. Everbright Securities in China was suspended three months from trading after their incident last Friday August 16; wouldn’t this type of sanctions catch firm’s owners’ attention?
I agree with Commissioner Aguilar’s observation that senior officers need to take the most appropriate steps to ensure compliance. My fourth suggestion is to define a type of certification statement that would put the onus on CEOs to go beyond rubber stamping their staff’s decisions and declarations. It is not about having the most sophisticated kill switch in trading entities’ infrastructure; it is about management defining and constantly monitoring the appropriate criteria by which these switches will be activated. Conventional wisdom suggests that when people know they can and will be held accountable for their actions, their behaviors change. Furthermore, these new rules should make it easier for government officials to make fraud cases against executives found to have intentionally filed false certifications under perjury charges.
Finally, market participants appreciate visible leadership that goes beyond statements sent though your press office. Both individual and institutional investors would have felt more comfortable if they had seen you discussing the NASDAQ issue and the steps the SEC was taking to monitor their efforts to resume trading. If you would like to find a podium to address the community, let me invite you to keynote the upcoming High-frequency Trading Leaders Forum 2013 Chicago, October 8.
The issues that happened on August 22 are not about NYSE versus NASDAQ, KCG Holdings versus Citadel or Goldman Sachs versus Morgan Stanley. This is about the United States’ competitive standing as the world’s most sophisticated financial market, a position it has to keep at all costs.
I am looking forward to hearing from you,