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H&R Block Analogy For CAT And Combating Fraud - By Kelvin To, Founder And President Of Data Boiler Technologies

Date 03/09/2019


Kelvin To, Founder and President of Data Boiler Technologies

Using data exhaust from Order/ Execution Management Systems (OMS/ EMS) to report data into Consolidated Audit Trail (CAT) is possible. Firms however will most likely run parallel systems (build on top of existing OATS reporting platform, clearing, and/or trade capture systems) given different departments operate in silos.  I despise unnecessary duplicating or triplicating of data that increase vulnerability of hackers’ attack. I also despise the burden on broker/ dealers to report data to a ‘stale vault’ when data could have been analyzed directly at its originating source. Given that, I have a ‘2 for 1 solution’ that drawn on an analogy from H&R Block for CAT data collection and combating fraud.

H&R Block is one of the 13 tax preparation companies that partnered with IRS to offer FREE* online software for Federal Tax Return reporting. Average taxpayer spends 8 hours and $110 filing personal income taxes each year (see this). To address that, H&R Block and United Way championed the ‘My Free Taxes’ initiative. Noteworthy of this story:

  • The IRS does not have the budget to build and provide this service on their own;
  • While collecting tax return data, the tax firms concurrently analyze the data for likelihood of IRS audit;
  • The initiative eases taxpayers’ burden in preparing income tax return, thus reducing taxpayer non-compliance and complaint.

Flash Crashes and market surveillance reasons propelled CAT as a mission critical project for the SEC. It will cost several hundred million dollars to build. The expected annual maintenance cost is over a billion dollars. From day one, I was one of the critics of CAT project. As proposed it lacks an analytical framework embedded in the design and clock-synchronization challenge (see my 2016 submitted comments to the SEC here). Now, I see opportunity to make it work and the followings are my diagnosis of the CAT project:

  1. The SEC does not have the resources to build the platform on their own;
  2. NMS mandates the Self-Regulatory Organizations (SROs: FINRA and Stock Exchanges) to upgrade their surveillance systems in anticipation of CAT new and improved information;
  3. The SEC investigations team may focus their exams and limited resources on “high risk” trade irregularities, and may rely on automated surveillance to “boil the ocean” for a quick-check of everything;
  4. The current SEC commissioners are more receptive to innovative ideas from the industry;
  5. With FINRA replacing Thesys, the project may move forward quicker given their experience with OATS and their ability to rally industry support.

Putting myself into the shoes of OMS/EMS vendors, I think their propositions should be as follows: (a) the data is already there and analyzing the data where it is originated is better than secondary source/ regurgitated copies; (b) CAT data reporting can be part of the ‘front-to-back’ integration strategy for firms such as SimCorp and State Street - Charles River; and (c) FlexTrade’s cross-OMS aggregation function can be a huge competitive advantage if they can ease market participants’ concerns for data reporting differences between the U.S. regulatory requirements and Europe’s MIFID II requirements.

For us at Data Boiler, we would love the opportunity to partner with OMS/EMS vendors helping to manage the data submission part of CAT project. More so, we are interested in solving the analytical challenges for CAT and supporting the SROs in combating fraud. One of the key takeaway from the 2018 SEC roundtable on Regulatory Approaches to Combating Retail Investor Fraud is “acting quickly is very important”. This includes: preventing more people becoming victims of fraud scams, salvages to recoup losses, as well as how to improve the FINRA trade halt authority so that it can act quicker.

It is unfortunate that the biggest disconnect between existing ‘ex-post’ fraud investigation process and acting quickly to prevent fraud and protect investors is the sense of urgency only arise after weeks/ months after the incident happened.  T+5 days regulatory access to CAT data (especially for flash crash investigation) is definitely too late. Typically, ‘the first 48 hours’ is the most critical time to curb further abuses and prevent unrecoverable losses. Scammers/ rogues are slick; details and speed are required to curb modern day abuses and agilely unwind to resolve complex issues across asset-classes and markets.  Given that a thousand trades can happen in between the 50 +/- millisecond tolerance time allowed by CAT, investigators ought to be able recognize irregular trade patterns amid toleration to the unsynchronized clock issue.

For that, I propose the following values-added features along the CAT data collection process:

  • Allow Data Boiler to boil the ocean to handle the preliminary trade analytics for and on-behalf of the SEC, FINRA and the SROs, so as to enable a real-time detection and early warning of trade irregularities for prompt actions;
  • We will provide to the filer a percentage indicating that the broker/ dealer’ trade activities may be subjected to the SEC/ FINRA/ SROs exams (giving the data submitters a comfort level if their transactions are ‘clean’ or need to be further reviewed);
  • We will provide a report of all identified trade irregularities to the filer, so firms can incorporate it into their Suspicious Activity Report (addressing concerns that investigators often found SAR currently missed reporting of many issues);   
  • We are also able to review consistency matters, monitor changes in risk profile and other indicators to assess if firms are acting in clients’ Best Interest (rather than in conflict or disregard of fiduciary principle);
  • We will be happy to work with the SEC, FINRA, and SROs by licensing our patent pending inventions to help build the industry’s next generation systems that consist of: trade reconstruction, order book replay simulator, advanced pattern recognition techniques, RENTD calculator, crowd computing, and more.
  • We would consider supporting the small investors by granting them a FREE* basic version of our analytical tools in order to level the playing field in the equity market.

The US public stock market is envy of the World. Yet, its significance is thwarted by a few greedy participants who take advantage of the system. Thankfully, the SEC and FINRA support investor protection, including but not limited to, enhanced transparency and disclosures, re-examining of 15c2-11 piggyback exception, possible revision to penny stock definition, scrutinizing transfer agent and other practices. Last, I’d like to use a quote by Jonathan Swift - “Laws are like cobwebs which catch the small flies and the wasps and hornet break through” to remind everyone that combating fraud isn’t just about pinning down small advisors who may have few lapses; there should be comprehensive investor protection against rogues of all sizes.

In the next article, I’ll unveil the solutions in solving the NMS market data fairness issue, so stay tuned.