The CAT is Out of the Bag: A Review of Rule 613 and New Trade Reporting Requirements

The CAT is Out of the Bag: A Review of Rule 613 and New Trade Reporting Requirements

by Jacob Shulman

In response to market manipulation the Securities and Exchange Commission (the “Commission”) has adopted Rule 613, creating the Consolidated Audit Trail (“CAT”). The rule mandates that Self-Regulatory Organizations (“SROs”) such as each national securities exchange, the Financial Industry Regulatory Authority (“FINRA”), and their respective members provide details to a central repository[1]. Years in the making[2], the primary goal of the CAT is to allow regulators to efficiently and accurately track a trade throughout its life cycle, linking all activity throughout the U.S. markets in National Market System (“NMS”), securities. NMS is the national system for trading equities in the United States, which includes the facilities and entities used by broker-dealers to fulfill trade orders.[3] At each stage in a trade’s lifecycle, there are risk levels and opportunities for illegal trading activity that the Commission seeks to mitigate.[4] The CAT system hopes to “connect the dots” in order to spot illegal activity. With the incorporation of CAT, trade data will be ready for review by regulators by T+5[5]. For example, trade data from a given Monday must be entered into the CAT system by 8a.m. the following morning (Tuesday morning). This will give the CAT surveillance team an opportunity to review the data for errors, and afford the industry member an opportunity to rectify any errors. By T+4, Friday, the industry member will submit corrected data, which will be ready for review the following day. The new CAT system will require daily reports of trade data. These reports will include customer information, accounts of record, quotes sent to the exchange (with time stamps from members), and execution data. The reporting change is onerous and much more expansive than before because now all listed options such as market-making quotes, and clearing allocations, are required to be reported into CAT. Now, options traders, like Susquehanna International Group, Citadel, and DRW, will be subject to more scrutiny, and regulators will have better access to options trading data.

However, the new system is evolving daily. Although the first set of reporting data is due by the end of 2017, the fee structure is still pending. In other words, the Commission is deciding who will foot the bill for this innovation. Although industry members[6] vehemently oppose the fee structure, industry participants have passed along all fees associated with setting up the new system.[7] Any charges related to creating and maintaining the system will be paid by industry members through a fee structure, yet to be determined.

An alternative that may be available to regulators is the opportunity to clearly define market manipulation schemes, such as spoofing, layering, etc., in a guidance release. As it stands now, there is an ambiguous portion of the Dodd-Frank Act, the “Anti-Spoofing Provision,” which encompasses many algorithmic trading schemes. Spoofing is a disruptive algorithmic trading entity employed by traders to outpace other market participants and manipulate commodity markets. Under the 2010 Dodd-Frank Act, “spoofing” is defined as “the illegal practice of bidding or offering with intent to cancel before execution.” Although three cases have been brought under this definition[8], as it stands, there is a lack of guidance regarding what trading practices constitute market manipulation. The first criminal conviction of commodities fraud and spoofing, of Michael Coscia, was recently upheld in August 2017. Mr. Coscia created an illusion of demand through “spoofing”, where an entity places bids to buy or offers to sell futures contracts with the intent to cancel them before execution. More specifically, the broadness relates to the intent to cancel, which applies to many trading practices that significantly vary from spoofing. For better court adjudication, and agency enforcement, the Commission, Congress, or the Supreme Court need to address this ambiguity. Additionally, the latest cybersecurity incident with the Commission’s central repository, EDGAR, has led to skepticism with CAT. Although the first deadline is upcoming, November 2017, lawmakers are calling for a delay. Namely, the Chairman of the House Financial Service Committee, Jeb Hensarling of Texas, expressed concerns that the Commission will have access to yet another data repository. With all of these concerns and issues, the Commission continues to move forward.

[1]System specifications, and a wide range of other information, is available at catnmsplan.com. Thesys Technologies, LLC is the Plan Processor for the CAT NMS Plan.

[2] Consolidated Audit Trail (Proposing Release No. 34-62174; May 26, 2010).

[3] This includes major stock exchanges.

[4] For instance, one can manipulate prices. The trade lifecycle includes Order Building, Order Creation, Exposure to the Open market, Block Execution, Clearing, and so forth.

[5] T+# indicates the number of days after an event or, in this instance, the number of days after the trades occurred.

[6] Industry members are, for example, broker-dealers, whereas industry participants are exchanges. For more information on specific opposition to the fee structure, see e.g., Letter from Joanna Mailers, Secretary, FIA Principal Traders Group, to Brent J. Fields, Secretary, SEC (June 22, 2017) (“FIA PTG Letter”); Letter from Daniel Zinn, General Counsel, OTC Markets Group Inc., to Brent J. Fields, Secretary, SEC (June 13, 2017) (“OTC Markets Letter”); Letter from Patricia L. Cerny and Steve O’Mally, Compliance Consultants, to Brent J. Fields, Secretary, SEC (June 12, 2017) (“Compliance Consultants Letter”); Letter from Theodore R. Lazo, Managing Director and Associate General Counsel, SIFMA, to Brent J. Fields, Secretary, SEC (June 6, 2017) (attaching Letter from Theodore R. Lazo, Managing Director and Associate General Counsel, and Ellen Greene, Managing Director, Financial Services Operations, SIFMA, to Brent J. Fields, Secretary, SEC (July 18, 2016) (“SIFMA Letter I)) (“SIFMA Letter II”); Letter from Cristina Crouch, Smart ltd (June 5, 2017).

[7] CAT also differs from the prior reporting system, Order Audit Trail System (“OATS”) insofar that there are no exceptions or exemptions. The trade data needs to be reported and monitored. However, options market makers quoting will be reported by the exchanges. An options market maker provides liquidity to an option by sending many quotes into the exchanges so that more trades can occur.

[8]See e.g., United States v. Coscia, No. 16-3017, 2017 WL 33814433, at *4 (7th Cir. Aug. 7, 2017).