Posted September 2013
As published in Traders Magazine , September 20, 2013
Until this past August, almost everyone outside of the financial services industry had neither a clue nor a care as to what the Securities Information Processor - SIP- was and its purpose in the market. That all changed on Aug. 22, when the tape C portion of the Nasdaq OMX pricing feed suffered a massive failure and the market maker was forced to halt orders of all Nasdaq-listed securities for three hours.
Today there are 16 registered stock exchanges that fall under Section 6 with the U.S. Securities and Exchange Commission. Each of those exchanges also distribute private data feeds outside of the SIP, so why were they forced to close that day?
It comes down to age. While we commonly refer to today's market structure as fragmented, the SIP dates back to nearly 40 years ago, when Congress passed the Securities Act Amendments of 1975. With an eye toward the future, Congress correctly recognized the emergence of technological advancements in the markets and ordered the SEC to create a national market system with market data at the center of the debate.
Thus, the Consolidated Tape Authority and SIP were born, and they continue to be run and funded by the exchanges through the collection of market data fees. The SIP is a central collection point whereby all exchanges must submit their best bids and offers, which are then redistributed to brokers and investors.
Another key piece of rule-making by the SEC made its debut in 1980. The Vendor Display Rule requires any vendor or broker of market data to provide the National Best Bid and Offer including top of book size. The rule was created so that investors wouldn't receive misleading or narrow views of the best trading price of a security. Thus, the Vendor Display Rule required brokers to become consumers of the SIP. At the time it made sense. In 1975, Congress, the exchanges and the SEC were grappling with significant changes in market structure. The Dow Jones climbed to 852, up more than 38 percent from the prior year. Fixed commissions were abolished, trading was extended to 4 p.m., and a record 35 million shares were trading daily while market data rates were bolstered to handle more than 36,000 messages per minute.
Could Congress have ever have imagined what a bottleneck those rules would create 40 years later? At the time, they surely could not have envisioned the exponential growth of exchanges, market data volumes and electronic trading speeds. Yet even with this unimaginable growth, it's ironic that today's issues are not that different from what they were back in 1975. In fact, those very rules designed to promote competition may actually hinder competition, harm market structure and increase costs today.
In 1999, then-SEC Chairman Arthur Levitt commissioned a committee chaired by Washington University Law School Dean Joel Seligman and made up of industry representatives and academics to provide recommendations on market data structure. Of the many recommendations issued by the committee in 2001, a narrow majority comprised of NYSE, AMEX, Nasdaq, institutional investors and academics favored retaining the Vendor Display Rule, thus maintaining the status quo and the SIP. On the dissenting side Island, two online brokers, market makers and market data vendors argued that market forces and the principal of best execution should pave the way for a new realm in high-speed market data vendor choice. The Seligman study also recommended expanding the SIP from the current NBBO structure to include a greater amount of depth. This recommendation was also reiterated in a TABB study about the SIP, titled "Circus of the Absurd," from 2011.
While there were many notable and sound recommendations in the Seligman study, not a single recommendation was ever enacted by the SEC.
By all accounts, today's SIP is extremely fast, considering that since 2006 average quote latency declined from 800 milliseconds to less than 0.6 milliseconds today-a significant increase. The SIP has also increased system capacity from 11,250 quotes per second in 2006 to more than 2.5 million by 2012 with plans of 3 million by October of this year. Overall latency is measured from when the participant sends the order to the SIP to the time the order is disseminated by the SIP, so what's perplexing is that even though the Vendor Display Rule was designed to provide the investor with a complete view of the market, the rules surrounding the dissemination of consolidated data are vague under Rule 603(a) of Regulation NMS, which requires exchanges that distribute market data do so on terms that are "fair and reasonable" and "not unreasonably discriminatory."
The SEC has been taking a harder look at latency, and in 2012 it fined the NYSE $5 million for failing to comply with Rule 603. It further cited that the NYSE had no formal compliance program for the rule. Compliance and oversight seem to be a common theme in even the latest Nasdaq SIP failure.
With that in mind, the Unlisted Trading Privileges Consolidated Tape Authority Committee (UTP/CTA) discussed several short-term actions to undertake. Some of these steps include:
--Improve structural framework. The committee agreed to consider several proposals from Nasdaq OMX, as the operator, that would tighten the structural framework and provide additional clarity around roles and responsibilities.
--Strengthen SIP technology architecture. The SIP implemented a solution that will automatically disconnect the front-end and back-end processors when a fail-over occurs.
--Enhance operational integrity. The SIP will manually terminate connections if unusually high traffic is experienced on a single port. In addition, they will disable a single participant in such a situation to ensure the integrity of the SIP and stability of the market.
--Increase frequency of stress and failover testing. The SIP will be available every weekend for testing. Market participants are encouraged to perform stress and failover tests after making code changes. Nasdaq OMX has recommended to the SIP committee that it create a formal certification process for any significant changes that can affect interaction with the SIP.
But don't look for any quick fixes from the committee that oversees the SIP, as the governance structure is as mysterious as the committee itself. The committee is comprised of each exchange that carries a vote, along with five advisors who came aboard after the passage of Reg NMS in 2005. Each exchange is a voting member, and any decision must be agreed upon by all voting members. Conversely, the advisors are not voting members nor allowed to vote or discuss pricing issues. That virtually all the exchange participants are now for-profit, publically traded companies that compete against one another makes that process all the more difficult.
The SIP is an old and antiquated system that has not kept pace with the rapid changes to our national market system, and because it operates in a market structure so drastically different from what was intended or ever envisioned, reform should be paramount. In today's marketplace, data should be sold and purchased directly by the consumer; this increases price competition and negates issues and concerns with latency over private/public data feeds. The Vendor Display Rule is a relic from the past and should be abolished and replaced with brokers fiduciary responsibilities to be the deciding factor with SEC oversight rather than forced consumption. The UTP/CTA committee itself should either be abolished or structurally changed from requiring unanimous approval to a majority.
While it is unfortunate that the failure of a key piece of industry infrastructure happened, perhaps the unintended benefit is SIP reform is finally on the front burner.