A First Look at Regulation System Compliance and Integrity

By Jim Northey, Principal Consultant and Industry Standards Liaison, CameronTec Group

Jim NortheyTechnology has created many efficiencies and benefits for the financial industry. However, it is an unfortunate truth that many drawbacks come along with the advantages that are gained. Unforeseen errors are an inevitable reality; some are small enough to go unnoticed by the majority, while others are large enough to shake confidence in the markets and in some cases (such as the Knight Capital glitch in 2012) threaten the well-being and existence of a firm.

In light of market dependence on complex technology, the industry needs to increase efforts in terms of overall system reliability and quality. The Securities and Exchange Commission (“SEC”) addressed this issue by unanimously adopting Regulation System Compliance and Integrity (“Regulation SCI”) in November of 2014 to ensure systems are operating with efficiency in the areas of capacity, integrity, resiliency, availability and security. Originally proposed in March of 2013, the regulation, in short, “establishes uniform requirements relating to the automated systems of market participants and utilities.”

This article will provide background on the events that led up to the proposal and eventual adoption of Reg SCI and which market participants are currently subject to it.

A Brief History of Regulation System Compliance and Integrity
2010 Market Review
More than five years ago in January of 2010, Mary Schapiro, then-Chair of the SEC, asked her staff to begin a comprehensive review of the equity market structure. “It was a review that included gathering views on everything from the impact of high frequency trading to the continued rise of dark pools, to the complexity of a multi-venue market system. The focus was not so much on the infrastructure of our markets,” Schapiro said, “but on the way the markets and market participants operate and behave.”

The review included an evaluation of equity market structure performance in recent years and an assessment of whether market structure rules have kept pace with, among other things, changes in trading technology and practices. The SEC sought public comment which they used to “help determine whether regulatory initiatives to improve the current equity market structure are needed and, if so, the specific nature of such initiatives.”

Flash Crash and AftermathA Brief History of Regulation SCI
Not long after the review took place, the Dow Jones plunged nearly 9% on May 6, 2010, in an event that is now infamously known as the Flash Crash. Soon after the Flash Crash took place, the Joint CFTC-SEC Advisory Committee on Emerging Regulatory Issues was formed. This committee’s job is to “address market structure and regulatory issues that may contribute to volatility.”

During the beginning of the following year, in February 2011, the committee issued recommendations regarding a regulatory response to the Flash Crash. The 14-page report tackled volatility, restrictions on co-location and direct access, and liquidity enhancement issues. The committee outlined 14 recommendations in these areas, which they considered the “most important ones upon which to focus to ensure the integrity of the markets” and to “maximize investor confidence in the aftermath of the many market disruptions over the past several years.” While also acknowledging that there are many other issues that still need to be covered, the conclusion of the response urges the SEC “to continue to use the events of May 6 and the subsequent analysis in their future market structure discussions and rulemaking.”

Roundtable Discussion
Over a year later, on October 2, 2012, the SEC held a roundtable focused on automated trading systems and how regulatory structure could be implemented. This roundtable sparked substantial discussion that would be used in the future to help revise the proposed Reg SCI to its final form.

At the roundtable, several of the panelists called for “implementation at trading firms of quality management systems and specific processes aimed at reducing the incidence of errors.” It was acknowledged that such measures would not eliminate all errors, for which reason mitigating solutions such as kill switches would be necessary. What was not made clear from the discussion was who would operate those switches, how they would be triggered, or how much control regulators would exercise over the process.

Proposal and Adoption of Reg SCI
As industry dependence on technology continued to heighten, Reg SCI was proposed in March 2013 as a response. The SEC initially welcomed comments on the proposal for a 60-day period, which was later extended to 105 days. At the end of the comment period, the SEC had received over 60 comment letters from a variety of submitters. Taking the comments into consideration, Reg SCI was passed on November 19, 2014, and published in the Federal Register on December 5, 2014. The final rule keeps the majority of the language from the initial proposal intact, but does feature several changes to address issues that were raised during the comment period, as well as the automated testing roundtable that was held in 2012.

Effective Date
Regulation SCI became effective on February 3, 2015, 60 days after its publication in the Federal Register. While the SEC understands that entities will need adequate time to prepare for and meet the requirements of Regulation SCI, they have decided to adopt a compliance date for entities subject to Regulation SCI of nine months after the effective date, with few exceptions. Many commenters suggested longer compliance periods or phased-in compliance periods, however the SEC has stated they believe entities need to comply to the rules of Regulation SCI as soon as possible, given the substantial number of system issues that have happened in recent times and in order to strengthen the technology infrastructure of key market participants.

How long do I have to comply?
SCI entities have nine months after the effective date of February 3, 2015, to comply with the regulation. There are only two exceptions to the compliance date for SCI entities:

  • ATSs newly meeting volume thresholds will have an additional six months from the time that they first meet the applicable thresholds to comply.
  • Entities have 21 months from the effective date to comply with the industry- or sector-wide coordinated testing requirement.

How am I affected?
Who must comply?
The SEC made it clear that Regulation SCI should apply to those entities that they consider the most essential to the efficient functioning of the US Securities markets, which in this case consists of certain self-regulatory organizations (“SCI SRO”), alternative trading systems that satisfy equity volume thresholds (“SCI ATS”), plan processors, and exempt clearing agencies subject to Automation Review Policy (ARP). Collectively, these participants are referred to as “SCI entities.”

In total, there are 44 SCI entities currently subject to the regulation. The breakdown is as follows:

  • 27 SCI SROs
    • 18 registered national securities exchanges
    • seven registered clearing agencies, including DTCC and NSCC
    • the Financial Industry Regulatory Authority (“FINRA”)
    • the Municipal Securities Rulemaking Board (MSRB)
  • 14 SCI ATSs
  • Two plan processors
  • One exempt clearing agency subject to ARP

Regulation SCI states it applies to “systems operated by or on behalf of” these entities – which means that covered systems operated by third parties do fall under the new regulation. Another detail is that the SEC left the regulation open to the option of expanding compliance to other market participants in the future. Therefore, if you do not currently meet the criteria of an SCI entity, it is possible that you may be effected later on.

Definitions of SCI Entities
SCI SRO
SCI SROs include all national securities exchanges registered under Section 6(b) of the Exchange Act, all registered securities associations, all registered clearing agencies and the Municipal Securities Rulemaking Board (MSRB).

There are two exceptions, including 1. an exchange that lists or trades security futures products that is notice-registered with the SEC as a national securities exchange pursuant to Section 6(g) of the Exchange Act and 2. any limited purpose national securities association registered with the SEC pursuant to Exchange Act Section 15A(k).78

SCI ATS
Any ATS that during at least 4 out of the 6 preceding calendar months, in respect to NMS stocks had 5% or more in any single NMS stock and .25% or more in all NMS stock, OR had 1% or more in all NMS stocks’ average daily dollar value. With respect to non-NMS stocks and for which transactions are reported to a SRO, any ATS that had .5% or more of the average daily dollar value as calculated by the SRO to which such transactions are reported is included as an SCI ATS.

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