News Journal: Just like airplanes, markets need a ‘black box’

Last week, the New York Stock Exchange experienced what it called a “technology glitch” and halted trading for three-and-a-half hours.

Ho hum. Not long ago, there would have been worldwide market disruptions had such a thing happened. But over the past few years, the NYSE has lost its place as by far the most important American exchange. It once handled 80 percent of all stock trading in the United States. That percentage has declined to about 14 percent. It is now one of just 11 exchanges and more than 50 private venues (“dark pools”) where U.S. equities are traded. Traders had no shortage of alternatives while the NYSE was closed.

That’s good news, of course. But the decline of one pre-eminent exchange, along with the increasing sophistication of super-fast computer-generated trading, has also had a disturbing downside. Back in the days of genuine ticker tape, we could monitor the moment by moment listing of trades. Prices were transparent. If anyone tried to game the system, there was a paper trail that the SEC and other regulators could access to determine what actions they should take.

They had what you might think of as a kind of black box. We are all familiar with the black boxes airlines install in their planes. In the unlikely event of a crash or some kind of system failure, when the black box is recovered the Federal Aviation Authority has a record of exactly what happened. That record is critically important, because the FAA is able to make recommendations and enforce new rules that prevent future accidents. Information from black boxes has made air travel much safer.

Five years ago, I realized our financial regulators no longer had anything like a black box to track market activity. Our markets had risen to worldwide pre-eminence because of their transparency and fairness to all investors. But in just a few short years, the shift from analog to digital trading had made high-frequency trading possible. HFT uses computer algorithms to make millions of trades possible in a matter of seconds. But there have been no similar technical developments that allowed regulators to track that trading.

Did HFT and dark pools give major market participants a way to manipulate markets? Had our markets become unfair to individual investors? It seemed highly likely to me, but without some kind of black box mechanism there was no way to prove it. So, back in 2010 when I was in the Senate, I wrote to, and then met with, the chairs of the SEC and the Commodities Futures Trading Commission. I suggested that they establish a Consolidated Audit Trail that would allow regulators to accurately track trading activity in all trading venues.

They agreed with me, but it was not until July 11, 2012, that the SEC did anything at all, finally issuing a press release that said, “The Securities and Exchange Commission today voted to require the national securities exchanges and the Financial Industry Regulatory Authority to establish a market-wide consolidated audit trail that will significantly enhance regulators’ ability to monitor and analyze trading activity.”

After three years, the SEC announced it had cut from 10 to six the number of bidders for the contract to build the Consolidated Audit Trail. I guess you could call that progress, although those bidders include FINRA itself. That kind of muddies the waters, because, as The Wall Street Journal reported, “Some critics, including stock-broker groups, have complained that FINRA is conflicted since it is bidding for the contract and deciding who wins.”

Our equity markets are essential to promoting capital formation and economic growth. The very last thing any of us should want is to lose the world’s confidence in the fairness and efficiency of those markets. If they took the long view, even HFT traders would agree with that. But of course they don’t take the long view, because in the short term the profits are simply too great to resist.

Last week I promised to remain a broken record on the subject of banks that are too big to fail. Add the development of CAT to my short list of things I won’t stop talking about until they happen.

The credibility of our markets is too important. We need a black box, and we need it now.

Ted Kaufman is a former U.S. Senator from Delaware.