Regulation Systems Compliance & Integrity (SCI)

Commissioner Kara M. Stein

Nov. 19, 2014

I also want to thank the staff in Division of Trading and Markets for their work on this important market structure rule, including David Shillman, Heidi Pilpel, David Liu, Sara Gillis Hawkins, Yue Ding, David Garcia, and Elizabeth Badawy. In addition, thank you to Jennifer Marrietta-Westberg, Amy Edwards, Chris Meeks, Seung Won Woo, and Mike Watson from the Division of Economic and Risk Analysis. I also want to extend my gratitude to Todd Scharf, Ed Schmidt, and the Technology Controls Program team from the Office of Compliance, Inspections, and Examinations for their important contributions.

Advances in communications and technology have had a profound impact on the trading of securities. From the first telegraph in 1846 to the electronic transmission of vast quantities of information in microseconds over the internet, the speed of orders from customers to brokers to execution has accelerated dramatically.

For decades, trading of securities occurred through the face-to-face interaction of individuals on an exchange´s trading floor. In fact, the movement to automated systems was originally meant to support, not eliminate, the trading floor. Accordingly, the SEC´s regulatory paradigm focused on this human interaction.

However, securities´ trading has evolved significantly, and most trading now happens through smart order routers and sophisticated computer algorithms. Face to face meetings have been replaced by tiny flashes of light. Trading centers have been decentralized with U.S. equity volume increasingly occurring on alternative trading venues.[1] Orders can move through various electronic pathways to an array of trading centers[2] for execution and fulfillment with little or no human intervention.

While these advances have made our securities markets lightning fast and more competitive, they also have exposed them to new vulnerabilities. The Commission´s regulatory approach has not kept pace. Today´s rule addresses the dominant role that computers now play in our securities markets, and the rapid speed at which securities are now purchased and sold.

Recent market events demonstrate that our rules need to evolve so that they can continue to protect investors and ensure fair and orderly markets.[3] Our financial markets are now completely interconnected by computers, which are prone to hardware failures and software errors. Because of this interconnectedness, when hardware fails or software malfunctions, the entire system can be affected, as we learned during the Flash Crash.[4]

Despite everyone´s best efforts, computers are going to fail; software is going to malfunction; and human errors will continue. "Bugs" and "glitches" cannot be fully eradicated. However, we can and should find ways to minimize the impact of these problems on our larger financial system. Technology disruptions and failures erode confidence and trust in our markets.[5] We need to all work together to make our securities markets more reliable and resilient when such inevitable disturbances occur.

Stable and reliable markets give investors around the world the confidence to invest. Those investments help our nation´s businesses grow, prosper, and create jobs for millions for Americans. Those investments help Americans buy homes, save for retirement, and pay for their children´s educations. When investor trust waivers, so does the well-being of our entire economy. [6]

The rule before us today is an important first step. However, it is only an initial step toward recognizing the challenges of our computerized marketplace and beginning to reorient our regulatory paradigm away from its traditional focus on human interaction. Regulation SCI will, among other things, require approximately 44 entities to establish written policies and procedures reasonably designed to ensure that their systems have the capacity, integrity, resiliency, availability, and security adequate to maintain their operational capability.[7]

But this is not enough. Specifically, today´s rule leaves out over 4,400 broker-dealers[8], 32 alternative trading venues trading equities, and 43 alternative trading venues trading fixed income and other non-equity securities.[9] It also leaves out all broker-dealer trading centers and other alternative trading venues, including those involved in complicated swap transactions, even though they may account for more than 22% of the equity dollar volume. Put another way, around $14 trillion worth of equity trades are ignored by Regulation SCI.[10] We should be doing more in this rule. I am disappointed in this missed opportunity because so many important trading centers are left out.

Further, the rule also ignores intraday proprietary trading firms that use sophisticated algorithms to interact at high speeds with the market. These algorithms can have a tremendous impact on the system.[11] When any computer connected to the equity market can send out hundreds of thousands of orders every second over extremely high-speed connections across multiple trading centers, they need to be part of the solution too. Risky or lax practices from any market participant should not be able to spill over and affect the reliability of the entire system. Everyone needs to do their part.

Shouldn´t everyone with direct access to the trading centers have to implement basic policies and procedures to ensure that their computer systems are stable, secure, and contribute to resiliency in our market? Just as we license drivers and register and inspect vehicles for the safety and soundness on our nation´s roadways, shouldn´t there be minimum requirements or standards for anyone with direct electronic access to the equity markets?

The principled-based policy and procedures approach in Regulation SCI is flexible and scalable, and merely requires all entities to have "reasonable policies and procedures" appropriate for their activities. Consequently, there is little reason to ignore so many firms with direct electronic access to the securities markets or those executing trades that can affect the system.

It´s only fair to require everyone accessing the system to do their part to ensure that the nation´s securities trading infrastructure is sound. It must be able to withstand stress, and it must be dependable. It is not acceptable for a few to bear the impact of all technological issues when we know firsthand that just one computer directly connected to the market can cause significant damage.

We must do more.

All firms with direct access to the markets and execution venues should be required to have procedures for testing their systems to ensure that they don´t cause market failures. And testing should be thorough. In addition, material changes to critical market systems should be independently tested and verified. All connected systems should be resilient, so that they can adapt and respond to challenges.

Regulation SCI is an important first step at tackling the inherent vulnerabilities in a marketplace dominated by computers. All plugged-in market participants need to do more to protect both the soft and hard components of our market infrastructure. Scalable, flexible, principle-based standards are an important step, but much more can and needs to be done to enhance the marketplace going forward.

I am encouraged by Chair White´s commitment to actively consider extending a rule like Regulation SCI to other key participants, such as broker-dealers and transfer agents. In my view, it´s not only necessary, but critical to ensure a sound and stable financial system that continues to attract investors and businesses from around the world.