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CAT Compliance: Evolution, Errors, and a Look Ahead

The 2010 Flash Crash, a market crash where stocks plummeted and rebounded in a matter of minutes, brought to light an immediate need for a new order audit trail system that would house every order’s transaction data, including options trading and market maker order and quote submissions. In theory, this new system would provide the SEC with more control and establish set regulations to prevent something like a ‘flash crash’ from happening again. At the time there was the Order Audit Trail System (OATS), which focused on equity orders and executed trades from FINRA member firms. However, there was still an immense need for a system that reported on additional aspects of trading, such as options trading and customer data, among other key metrics. Then came the Consolidated Audit Trail (CAT) in 2019 – essentially a one-stop shop database designed to quickly and efficiently spot trends and anomalies throughout the industry.

The Right Database at the Wrong Time

The intention behind CAT – tracking all trading and order activity in the U.S. markets to ensure security and transparency – was necessary for the industry. Despite its good intention, CAT has made it substantially difficult for some trading firms to stay afloat. A new and expansive database like CAT comes with technological learning curves and the need for companies to employ designated teams to help support and comply with CAT. Because most phases of CAT were deployed during the pandemic, firms did not have the financial bandwidth to hire their own tech developers or a third-party vendor to take on the additional work. Sadly, this meant many firms – both big and small – were forced out of business, which limits competition, increases barriers to entry due to CAT, and hurts the overall strength and diversity of the industry.

Implementing CAT: A Cautionary Tale

In 2020, when uncertainty was at its height and firms were navigating some of the biggest challenges they’ve ever faced, trading firms had the added obstacle of complying with FINRA’s mandate to report to CAT. However, because the SEC and FINRA frequently changed launch dates, many industry professionals were unsure whether this mandate would happen. Unfortunately, those firms were, and still are, ill prepared and lacked the necessary knowledge to implement.

To use an analogy, CAT operates like a daisy chain. In a daisy chain, there are several pieces that need to be documented in order for everything to work properly. If one piece is out of sorts, the system crumbles. In the simplest terms, each firm that is part of a trade must add its piece properly or else the chain cannot be complete.

Sounds straightforward, right? Except when a firm is executing millions, or even billions, of trades daily, things can quickly become quite complex and easily missed. From an incorrect ID number to a broken link to another party failing to complete their portion – the list of errors that can upset the system goes on and on.

To put it into perspective, as a CCO of a Chicago-based proprietary trading firm, I receive thousands of linkage breaks a day. Each break requires me to reach out to each individual counterparty to figure out what happened and fix it before the FINRA issues a t+3 deadline (trade date plus three days) for corrections.

Knowledge is Power: Understanding CAT

In addition to being an enormous database housing billions of trades a day, CAT was created to keep up with the ever-changing technology throughout the industry. Before CAT, high-frequency trading technologies became increasingly advanced, making it harder and harder for regulators to keep up. This caused significant setbacks as they fell months – or even years – behind. As CAT reporters observed this growing trend, the SEC knew the execution of CAT was necessary.

CAT has been my focal point for nearly three years, as I expected this rollout to be filled with bumps in the road and understandable confusion. I made it my goal for my team at Simplex Trading to be well-prepared and aware of what was to come, as well as equipped with the tools and knowledge to seek solutions to any issue that inevitably arose.

Not only do I continuously inform and educate my teammates, but I also feel an ongoing passion to educate those across the industry. Whether that be providing the basic tools and information on how to report to CAT or helping to solve errors detected, I make a great effort when working with other professionals to be proactive in my approach. This is because I have seen time and time again what happens when companies cannot keep up. Knowledge, especially about CAT, is power.

I have also witnessed the important role third party reporters play since CAT was mandated. Although this option can be costly and time consuming for firms, it can sometimes be the best option to avoid being audited. So, connecting customers or other firms with these third parties and operating as the “liaison” has been a priority of mine and is often extremely beneficial to those looking to expand their teams.

What challenges does CAT bring about?

Rule consistency is a significant struggle I see amongst regulators. While the same rules should be applied consistently across our industry, they’re not and it causes frustration and discouragement. Rules are constantly becoming outdated because the industry itself moves and evolves faster than the rules can be updated. So, firms are repeatedly caught in perpetual limbo between what the rules state and how the regulators interpret them.

To ensure consistency, the SEC/FINRA’s rules and their interpretations should be updated to be identical among all regulators and industry participants. This would also help diminish hesitancy that still lingers around CAT, as well as eliminate a great deal of confusion. The solution may be having regulators leverage the knowledge of these industry participants to make this as valuable and efficient of a tool it can be.

Additionally, the price of CAT is a major fear and a potentially costly unknown for firms. Although nobody has been charged yet, it’s only a matter of time before the SEC and FINRA put a price tag on CAT reporting. Some conversations have focused on charging firms based on order flow – and for firms with millions of orders daily, it could mean millions of dollars every quarter. For firms to simply survive in the industry, the SEC and FINRA should rethink the effects on business longevity and vibrancy.

The future of CAT

CAT continues to be a work in progress and there are still plenty of ‘what-ifs’ and ambiguity when it comes to mandated rules. To alleviate some of the uncertainty, it would benefit the SEC and FINRA to listen to those doing the reporting – the trading firms. To help resolve inconsistent interpretation of the

rules amongst reporters, it would be encouraging to see more real-world industry participation in the drafting of these rules and the interpretation of how the rules are written today. And just as important when it comes time for revisions of the rules.

As an example, lawyers and experts outside the industry often write these rules; however, they don’t have the base knowledge and applicable day-to-day understanding of how the rules drastically impact the industry. For regulations that should be flexible depending on a firm’s expertise – such as options and futures trading – they are instead set as black and white, making it extremely difficult for the industry to adapt to the ever-evolving market.

Looking ahead, I hope there is a greater discussion around CAT between all parties it touches. No firm should have to close its doors or be unfairly targeted because of CAT. With increased conversations and collaboration, this reporting system will be highly effective – for both the SEC/FINRA and industry members.

Author Biography: Angela Lucas is Chief Compliance Officer of Simplex Trading, a leading technology-driven proprietary trading firm. Angela is passionate about compliance and loves the fast-paced, ever-changing environment of rules and regulations. In her role, Angela is responsible for overseeing and managing the day-to-day compliance responsibilities for the firm.