Remarks from the Security Traders Association Annual Conference

Richard G. Ketchum

Chairman and Chief Executive Officer

Washington, DC

September 20, 2012

As prepared for delivery.

Thank you John [Daley] for that introduction, and thanks for the invitation to join you this morning.

When I spoke to you last fall, I updated you on market structure changes and the volatility we've seen in the markets since the flash crash in May 2010. Since then, we've experienced other significant trading-related issues, including the Knight Capital trading glitch on August 1. Keeping up with computerized trading and market structure changes is a never-ending challenge for regulators. However, FINRA has made significant progress with cross-market surveillance. We recently launched multiple new cross market patterns that address more than 50 threat scenarios. And, as a result of the NYSE integration, we are now canvassing 80 percent of the equity market. With the planned implementation of a consolidated audit trail—which the SEC approved in July—we will be able to expand upon our cross market surveillance efforts. I will talk more about our work on the consolidated audit trail later.

Today, given the conference theme, I want to focus my remarks on some of the work FINRA is doing in market regulation, particularly with respect to options surveillance and examinations. There have also been some significant developments on the equity side that I want to address as well, and I will also talk briefly about the market access concerns arising from Knight Capital's trading issues. I'll start with the consolidated audit trail.

Consolidated Audit Trail

The SEC's new rule on the market-wide consolidated audit trail requires the exchanges and FINRA to jointly submit a comprehensive plan detailing how they would develop, implement and maintain a National Market System (NMS) that collects and accurately identifies every order, cancellation, modification and trade execution for all exchange-listed equities and equity options across all U.S. markets. As we've said over the years, a consolidated audit trail will enhance regulators' ability to conduct surveillance of trading activity across multiple markets and perform market reconstruction and analysis. Currently, each SRO has its own audit trail system, which means we don't have a single source of trading data. For example, FINRA has OATS, which now includes all NMS securities. A single, consolidated audit trail will provide a uniform set of order and trading information covering all U.S. NMS securities that regulators will be able to access. Once the consolidated audit trail is in place, we'll be able to close the regulatory gaps that currently exist and conduct broader, more effective cross-market surveillance. In doing so, we'll be better positioned to detect improper conduct at an earlier stage. We believe we can leverage OATS to become the foundation of the new consolidated audit trail and we are working with the other SROs to build consensus on an NMS plan that includes OATS.

While a consolidated audit trail will enable us to close the regulatory gaps that currently exist, it may have an even more profound impact on options surveillance. Currently, the options audit trail doesn't capture the level of detail that we collect for equities. For example, the consolidated options audit trail system—which is the primary source of data for options surveillance and in options-related investigations—does not contain order receipt or transmission times. This kind of detailed information about the life cycle of an options order will help level the playing field between equities and options surveillance and will help regulators better protect investors.

For example, we are often in a position where we need to get information about order receipt times from firms in order to assess a firm's knowledge of the existence of an order and potential culpability, and to determine whether there has been harm to customers in the context of frontrunning. The information provided by a consolidated audit trail will better enable regulators to see the movement and timing of events in the lifecycle of an order. This would also help us detect rule violations. And having such data would limit the amount of information that we need to request from the firms directly.

Our reviews of manipulation, such as spoofing, layering and other predatory momentum ignition strategies, across both product types will greatly benefit from the transparency resulting from a consolidated audit trail. As with equities, the inclusion of more detailed customer records will help us aggregate related options activity and identify bad actors.

Examination and Surveillance Programs

Turning to our options examination and market surveillance programs, we continue to enhance both programs to address areas we are concerned about and new variations of classic manipulation methods. Let me begin with the changes to our surveillance program. We've seen an increase in complaints about algorithmic activity that has grown out of a classic mini-manipulation scenario in which firms appear to have algorithms that move the underlying equity. Such an algorithm could allow a firm to take advantage of a pre-established options position. In some cases we are concerned about manipulation of the underlying equity in order to establish options positions at favorable prices or manipulate the options implied volatility. The speed of trading can amplify or perhaps make certain manipulative strategies more feasible because a move in the underlying equity will instantaneously impact the option pricing. This means that a manipulator does not need to move the equity for any extended period to have a significant impact on the options market. We have enhanced our surveillance reports to capture this type of activity.

Similarly, we have developed surveillance alerts to capture excessive message traffic arising from algorithms that update quotes at ferocious speeds throughout the options industry, sometimes with as many as several thousand options quote updates in one second without a change in the underlying price. We have received a large number of complaints in this area and we're looking at the reasonableness of the controls surrounding the algorithms and whether firms have the appropriate pre-trade checks in place. In many instances, firms have told us that the microbursts of activity are often due to algorithms that trip over themselves. Of course, in certain situations, the apparent excessive quoting is in fact due to rapid changes in the underlying security.

Another primary area of concern for us is the proper use of order-origin codes. We have seen situations where firms are improperly coding firm or broker-dealer orders as customer orders. Such mismarking causes significant problems across the options markets. Order priority can be impacted, the options audit trail is affected and exchange fees are underpaid. We are looking at the scope of the problem and are conducting a sweep of firms to help us determine if it's a significant issue. Our options surveillance and examination teams are looking at whether firms are deliberately trying to circumvent professional customer status, and thus maintain order priority status along with lower exchange fees. We are also working with other regulators to coordinate reviews of options origin codes.

We recognize that the order-origin code requirements differ across the various options exchanges and we are working with firms to help them properly identify origin codes across the industry.

Another area of concern is large options positions reporting. We have identified a large number of firms that are either misreporting positions or not reporting them at all. In some cases, a firm has no compliance oversight of the logic that it uses to determine its large options positions reporting obligations. Some of the issues involve position aggregation errors, in-concert reporting errors and the non-reporting of positions that are clearly within the scope of that which must be reported. These issues can affect industry-wide insider trading reviews, as well as other manipulation reviews that are essential to our options surveillance programs.

It is crucial that we work to correct significant large options positions reporting deficiencies. The options industry regulators have issued guidance in the form of frequently asked questions that are available on the OCC's website.

We continue to examine the use of the market-maker locate exemption to short stock and the subsequent "reset" of the close out obligations through the use of short-term option strategies. As many of you may know, during the past several years we brought a series of significant Reg SHO cases against options market-makers on behalf of our client exchanges. Many of these cases involved multi-million dollar sanctions and long suspensions against the traders involved with the misconduct. We also referred a number of cases to the SEC, which also brought significant sanctions, and we continue to actively pursue cases like these.

While Rule 204 of Regulation SHO has significantly limited the abuses we had previously seen with respect to close outs, we are still actively reviewing for such activity. We remain concerned that certain market-makers may try to find new and creative ways to circumvent the more restrictive rules. Further, the use of the market-maker locate exemption still remains an area where we see problems. Specifically, we are concerned about market-makers using the locate exemption when trading large blocks in securities where they are not registered, where they do not otherwise have options positions that resulted from bona fide market making, and where there is no exigency that would necessitate the use of the locate exemption.

We also remain concerned with situations where firms may see an advantage to exercising an option or, conversely, rescinding an exercise after the cut-off time on expiration. Such activity, when based on a news-related event, has been the focus of some significant enforcement actions over the past several years. We suggest that each firm conduct a rigorous review of late requests for a contrary exercise. Late submissions should only be permitted in situations where a bona fide error has occurred.

Let me turn now to our TMMS program. When I spoke to you last year, I updated you on the expansion of our TMMS program to include large order-entry firms, alternative trading systems, some non-market making desks of firms, as well as equity and options trading exams for eight SROs.

The options exam program focuses on trading rules. And unlike our FINOP and Sales Practice exams, these exams support and complement the automated surveillance efforts within Market Regulation by focusing on trading activity for which it is difficult to build an effective surveillance. These exams provide added transparency in areas such as order handling, information barriers, electronic communications and written supervisory procedures. Common findings of these examinations include the misuse of error accounts, Reg SHO violations, deficiencies in written supervisory procedures and the failure to retain electronic communication.

Market Access

Now, I want to spend some time talking about market access issues. As Knight Capital's trading glitch reminded us, a human or systems error can quickly compound and cause significant harm to the markets and investors. The cascading damage that errors can cause magnifies how important it is for firms to have robust controls in place.

As you know, in 2010, the SEC adopted the Market Access Rule, which requires broker-dealers to ensure they have adequate control of the customer and proprietary order-flow they send to the markets. The rule evolved from concerns that unfiltered or "naked" access to the markets can potentially harm investors and raise questions about the markets' integrity. Overall, firms have worked hard to build the controls required by the rule. However, it is important that firms remain diligent and proactively strive to implement improved controls because, as events have shown us, a single error or breakdown in these controls can cause massive harm. The rule is designed to ensure that firms have risk-management controls and supervisory procedures necessary to manage the financial, regulatory and other risks related to market access. This includes the access provided to customers. And, the controls must be applied before a broker-dealer routes an order to a market. Another important provision is that the broker-dealer must have "direct and exclusive" control of the procedures and controls, unless a limited exception applies.

In addition to the annual certification, firms must test the controls and related procedures at least annually to ensure they work as intended and are effective given the firm's current business activity. One example of such a test is to review alerts sent to risk management and/or compliance. Another is to test the hard blocks to prevent erroneous orders and other unwanted activity. Firms should consider testing the systems they use to monitor and identify problematic activity and early warning signs of such activity. And, it's important for firms to test their ability to stop trading when certain risk or other thresholds are met.

What else should you be thinking about? Depending on your business, you should consider whether a regular evaluation of the adequacy and reliability of "kill switches" to stop orders flowing to the markets under certain circumstances is necessary.

Ensuring robust and thorough testing of new algorithms and other software or hardware changes before live implementation is a best practice that aligns with the intent of the Market Access Rule. Such testing helps ensure adequate controls are in place to prevent customer or proprietary order flow from harming the integrity of the markets, the firm's viability, the reliability of orders, the prevention of erroneous orders and executions, and, of course, potentially violative conduct.

Robust compliance with the words and spirit of the Market Access Rule is essential to maintaining market integrity and helping restore investor confidence.


What we've learned from the trading glitches of the past two years is that a healthy financial market depends on strong compliance and internal controls. I encourage you to remain diligent and to implement improved controls where necessary. Maintaining the market's integrity and investor confidence depends on it.

Thanks for listening. I'll now take your questions.