Once again, the world’s equity markets are witnessing a period of dramatic change. Driven by advances in technology, changes in regulatory and competition policy, and the evolution of exchanges from mutual to publicly traded, for-profit entities, we are seeing the simultaneous consolidation of exchange markets and the concurrent proliferation of alternative trading venues. A spectrum of market operators, traders and investors has raised concerns about these developments and their implications for transparency and market fragmentation.
While these concerns have received considerable attention, the perspectives of regulators charged with maintaining the integrity of the market in this rapidly evolving landscape have received considerably less focus, but they are no less important and the challenges are many. Competing execution venues, cross border transactions, dark pools, high frequency trading, to name a few, all add complexity to the market and make surveillance for abusive practices substantially more difficult.
For regulators to prove equal to these challenges, regulatory structures, like markets themselves, must evolve. Based on FINRA’s experience, we believe several principles can serve as guideposts to this evolution:
(1) The regulatory structure should provide a holistic approach to regulation where regulators can monitor and detect problematic activity across products (i.e., equity, debt and derivatives) and not just within each market and market segment.
(2) The structure should guarantee sufficient granularity and aggregation of audit trail data across markets and financial products so that regulators can readily identify activities—such as direct market access, high frequency trading, and algorithmic trading, among others—and better design surveillance systems to detect market manipulation and other abusive strategies.
(3) The structure should ensure that audit trail data is transparent so that market participants’ trading activity is discernable to regulators, and prevents participants from masking their identity by using multiple identifiers or the identifiers of another broker-dealer.
Although developed with the U.S. market in mind, these principles are equally valid in a multinational context, but must be supplemented with a crucial fourth principle: There must be an effective governance structure to consolidate the interests of the multiple national regulators and to oversee the structure’s implementation.
What would a structure that supports these principles look like?
First, regulators must develop unified standards and procedures to govern the content, timing and publication of information for equities transactions regardless of the quoting or execution venue. These are discussed further below in the context of a consolidated quote and trade mechanism.
Second, to make this standardization effort effective, the regulatory framework must (1) test compliance with data standards systematically and comprehensively across all execution venues on a continuing basis and (2) provide useful outputs (i.e., alerts) for regulators to respond to patterns of non-compliance, regardless of the number or types of trading venues subject to their jurisdiction. In today’s market environment, testing compliance with the data standards is an essential exercise; without it poor quality data can undermine the effectiveness of even the most sophisticated surveillance systems.
Third, regulators must establish an appropriate governance mechanism for developing and implementing these measures on a cross-border basis. This will doubtless be complex, but there are a variety of vehicles—such as a college of regulators and bilateral or multilateral agreements—that could be used to address this challenge. Another option is to place the surveillance function in a regulatory utility funded by various market centers, but subject to oversight through an agreed mechanism.
Once the oversight and management structures are in place, there are a variety of options to implement the audit trail itself. And, in fact, many jurisdictions utilize multiple audit trails, typically one or more for post-trade data (i.e., trades) and one or more for pre-trade data (e.g., quotations and orders). In some markets there are separate sets of market transparency data (data to provide transparency to market participants) and regulatory transparency data (data to provide transparency to the regulator). This adds a further complicating aspect to an already complex picture and can result in the need to reconcile multiple, large data sets. In the United States, there is essentially a single trade reporting process that fulfills the legal requirements for market and regulatory transparency.
This last point deserves special attention because there appears to be an implicit assumption that a market that is transparent to participants is also transparent to regulators and vice versa. In fact, this is not the case: transparency for regulators is not the same as transparency for market participants. Markets can be transparent to one and not the other as well as transparent to both. A few examples illustrate this point. Dark pools are considered opaque to the market, but are transparent to FINRA from a surveillance perspective because of the audit trail data we receive. By contrast, while the publicly available trade and quote information is sufficient to make equity markets transparent to market participants, a regulator relying solely on this data would find the market relatively opaque; effective surveillance requires substantially more information. Finally, a regulator conducting comprehensive post-trade surveillance can receive high quality data on a T+1 basis or even later and still have adequate transparency. From an investor’s or trader’s perspective, however, this sort of time delay would render the market dark. Thus, transparency can be thought of as having at least three dimensions—availability, scope and timeliness—which should inform regulators’ thinking about their transparency requirements.
Internationally, there are a variety of approaches to providing post-trade data. In Europe, for example, two broad models are used to achieve a regionally consolidated transaction tape for equities transactions. One model builds upon commercially driven processes and infrastructure by requiring investment firms to publish post-trade data through one or more service providers. A second model mandates that all reportable trades be made available to, and published via, a single consolidated tape.
In many respects, the second model resembles the U.S. approach, which involves the use of a consolidated tape. Based on our experience, the statutory mandate for a consolidated tape has been achieved through a single data consolidator, with competition in data dissemination and data analytics to end users. This model continues to function effectively and has withstood many challenges. However, this model required that a single regulator, the U.S. Securities and Exchange Commission, have overarching responsibility for the policy outcomes and broad authority to implement the measures needed to achieve those outcomes. In a multinational context, a similarly effective governance mechanism will be necessary.
Pre-trade data is, of course, another essential element of any effective surveillance program. This includes consolidation of quotation information or top-of-the-book order prices as a component of a more integrated market for equity securities traded in multiple venues. Pre-trade data captured should also include full order details for orders accepted and processed (e.g., the data captured in FINRA’s Order Audit Trail System). These types of information are equally important for purposes of price discovery, judging best execution, and generating alerts and prosecuting cases around trading abuses (e.g., potential instances of price/volume manipulation or illicit insider trading).
As a practical matter, the most effective way to surveil for abusive trading practices across the wide range of market centers is to consolidate audit trail data in a single place so that violative trading practices can be more readily identified.As regulators look to the future, we must squarely address the surveillance challenges that evolving market structures present. We must have timely access to the data we need to ensure effective market surveillance. There must be an effective regulatory structure that keeps pace with the evolving market structure. And, regulators need a consolidated audit trail to effectively detect market manipulation and fraud. FINRA is working closely with the SEC, and other regulators, on these important initiatives that are central to enhancing regulators’ ability to best oversee today’s markets.
About Stephen Luparello
Stephen Luparello is FINRA's Vice Chairman. In this capacity, Mr. Luparello oversees FINRA's regulatory operations, including Enforcement, Market Regulation, Member Regulation and Business Solutions. Prior to this position, Mr. Luparello served as FINRA's Interim Chief Executive Officer.
Mr. Luparello began his tenure at FINRA (then NASD) in 1996 as Vice President of the NASD Office of Disciplinary Policy. He became the head of NASD's Market Regulation Department in 1999, with responsibility for oversight of trading on The NASDAQ Stock Market, the American Stock Exchange, the Over-the-Counter equities market, and the corporate and municipal fixed income markets. He has also overseen the organization's creation of cutting-edge market regulatory technology.
Mr. Luparello played a critical role in orchestrating the consolidation of NASD and the member regulation, enforcement and arbitration functions of NYSE Regulation to create FINRA in 2007. He also continues to lead FINRA's regulatory work for markets and exchanges in the United States—and in 2010, oversaw the agreement to perform regulatory services for NYSE Euronext's U.S. equities and options markets.
From 1994 to 1996, Mr. Luparello was Chief of Staff to the Chair of the Commodity Futures Trading Commission. Prior to joining the CFTC, he served four years as legal counsel to former FINRA CEO Mary Schapiro at the SEC, and as legal counsel in the SEC's Division of Market Regulation.
Mr. Luparello serves on the board of the Depository Trust & Clearing Corporation. He is a graduate of the Washington and Lee University School of Law and received his undergraduate degree in History from LeMoyne College.