Exchanges and clearinghouses would be required to maintain adequate technology systems and report disruptions under a U.S. Securities and Exchange Commission plan for the first update of automation principles in 22 years.
SEC commissioners are set to vote at a meeting today on measures that may also include large brokerages and dark pools in the requirement to regularly audit information systems for safety and stability. Companies would be required to stress test their automated systems for how they react to crises.
The SEC is working to minimize damage from failures caused by automated system errors such as the trading malfunction by Knight Capital Group Inc. in August, which almost bankrupted the firm and led to its sale to Getco LLC. Exchanges and clearinghouses for more than 20 years have been subject to a voluntary program relying on self-audits and SEC inspections.
“By making it a real rule now, you put more powerful enforcement teeth in it,” said James J. Angel, a Georgetown University finance professor who serves on the boards of two exchanges operated by Direct Edge Holdings LLC. “It shows they are taking seriously the stability of our IT infrastructure.”
The SEC has said it accelerated the proposal after the Knight Capital malfunction. The agency already has enacted rules requiring broker checks against erroneous orders and circuit breakers that halt trading during periods of extraordinary volatility.
The new rule could expand the program’s reach beyond exchanges and clearinghouses to large brokers and dark pools, David Shillman, associate director in the SEC’s division of trading and markets said in September.
In a speech two weeks ago, SEC Chairman Elisse B. Walter said significant alternative trading systems probably would be included in the proposal. Alternative systems include venues such as dark pools, which are more lightly regulated than exchanges and don’t have any self-regulatory responsibilities.
“A voluntary standard is no substitute for a mandate and a requirement that you must follow,” Walter told reporters after the speech.
The voluntary standard, known as Automation Review Policy, was created after the October 1987 market crash known as “Black Monday.” It was intended to ensure the exchanges had enough capacity to handle surges in trading activity.
The SEC last issued policy guidance about the program to exchanges and clearing firms in May 1991.
A report issued by the U.S. Government Accountability Office in 2001 said the SEC devoted limited resources to overseeing the voluntary guidelines. It faulted the SEC for relying on the exchanges and clearinghouses to self-audit their systems instead of using external organizations as an “independent check.”
The GAO also said the SEC hadn’t assessed the compliance of exchanges and clearinghouses with the voluntary guidelines.
Exchanges and most brokerages already follow standards similar or superior to the SEC’s voluntary guidelines, according to Georgetown’s Angel. Some brokers may have to strengthen their systems if the rule applies to them, he said.
“The exchanges are already under really close scrutiny,” Angel said in a telephone interview this week. “The real impact would be on the broker-dealers. It would give them a clear set of guidelines they have to follow.”
The SEC’s project to update the Automation Review Policy guidelines is one of several initiatives to improve the securities industry’s ability to manage automated trading. The agency’s market-access rule, implemented in 2011, requires brokers to employ controls to avoid orders that appear to be erroneous and exceed preset capital and credit levels.
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