United States: SEC Adopts Regulation SCI To Strengthen Controls For Technological Systems At Core Of U.S. Markets

I. INTRODUCTION

On November 19, 2014, the SEC announced the adoption of Regulation Systems Compliance and Integrity ("Reg SCI") in a 742-page release.1 Reg SCI is effective 60 days after publication in the Federal Register, and subject entities must comply with Reg SCI's requirements within nine months of that date.2 Once effective, Reg SCI will regulate approximately 44 entities, including securities exchanges and certain alternative trading systems ("ATSs"). While broker-dealer-operated ATSs meeting certain trading volume minimums are covered by the new rules, the SEC notably declined to extend Reg SCI to broker-dealers, generally. Reg SCI imposes rigorous standards for subject entities' technological systems and related policies and procedures. The regulation also includes extensive reporting requirements. Concurrent with the adoption of Reg SCI, the SEC staff also issued guidance relating to the policies and procedures subject entities should adopt. The following discussion addresses Reg SCI's key provisions related to its applicability and requirements and identifies issues raised by its provisions.

II. ADOPTING RELEASE

The SEC initially proposed Reg SCI on March 13, 2013 in response to perceived vulnerabilities in the nation's securities market structure, including those related to recent incidents such as the BATS IPO, the Facebook IPO, and Knight Capital's technology issue.3 The final rule largely tracks the initial proposal, with certain variations. Most notably, two key differences between the proposed regulation and Reg SCI as adopted are: (i) that the standards that subject entities must adhere to (discussed below) are no longer required to be widely available for free, but rather need only be widely available; and (ii) that the SEC will no longer require access to subject entities' systems, but will rely instead on required recordkeeping as a monitoring tool.

Reg SCI supersedes and replaces the SEC's current Automation Review Policy ("ARP")4 and the segments of those policy statements that were later codified in Rule 301(b)(6) of the Securities Exchange Act of 1934 ("Exchange Act"), which applies to significant-volume ATSs that trade NMS and non-NMS stocks.5 As discussed in more depth below, Reg SCI requires self-regulatory organizations, certain ATSs, plan processors, and certain clearing agencies to: (i) establish and maintain policies and procedures related to their technological systems; and (ii) provide certain notices and reports to the SEC.

III. APPLICABILITY

Reg SCI regulates any entity falling within the definition of an "SCI entity" defined as an "SCI self-regulatory organization, SCI alternative trading system, plan processor, or exempt clearing agency subject to ARP."6 The SEC intends this definition to cover those entities that play a significant role in the U.S. securities markets and/or have the potential to impact investors, the overall market, or the trading of individual securities.7 Reg SCI does not, however, cover OTC market makers, exchange market makers, order-entry firms, clearing broker-dealers or large multi-service broker-dealers. The regulation governs activity associated with the technological systems of SCI entities that are related to securities market activity.

A. SCI SRO

An SCI Self-Regulatory Organization ("SCI SRO") is any entity that is a national securities exchange registered under Section 6(b) of the Exchange Act, a registered securities association, a registered clearing agency, or the Municipal Securities Rulemaking Board. There are two notable exceptions: (1) exchanges that list or trade security futures products that are registered with the SEC as a national securities exchange pursuant to Section 6(g) of the Exchange Act, and (2) any limited purpose national securities association registered with the SEC pursuant to Exchange Act Section 15A(k).8

B. SCI ATS

An SCI alternative trading system ("SCI ATS") is any ATS that, during at least four of the preceding six calendar months:

  • Had 5% or more in any single NMS stock's average daily dollar volume ("ADDV") reported by applicable transaction reporting plans, and 0.25% or more in all NMS stocks' ADDV;
  • Had one percent (1%) or more in all NMS stocks' ADDV; or
  • Had with respect to equity securities that are not NMS stocks and for which transactions are reported to a self-regulatory organization, 5% or more of the ADDV as calculated by the self-regulatory organization to which such transactions are reported.9

Consequentially, entities that operate an ATS should closely monitor their trading volume.

The SEC believes that 12 unnamed entities currently fall within the definition of an SCI ATS.10 Any ATS that meets the SCI ATS thresholds, subsequent to the initial compliance date, has six months to comply with Reg SCI.11

C. SCI Plan Processor

A Reg SCI Plan Processor is any entity that meets the definition in Rule 600(b)(55) of Regulation NMS, which defines "plan processor" as "any self-regulatory organization or securities information processor acting as an exclusive processor in connection with the development, implementation and/or operation of any facility contemplated by an effective national market system plan."12

D. Exempt Clearing Agencies

Reg SCI also applies to exempt clearing agencies previously subject to ARP pursuant to Section 17A of the Exchange Act or any SEC regulation that supersedes or replaces such policies.13 An exempt clearing agency previously subject to ARP is defined as "an entity that has received from the [SEC] an exemption from registration as a clearing agency under Section 17A of the [Exchange] Act, and whose exemption contains conditions that relate to the [SEC's] [ARP], or any [SEC] regulation that supersedes or replaces such policies."14

E. Subject Systems of SCI Entities

Reg SCI applies to the specific systems of an SCI entity that directly support the six areas that the SEC has determined to have traditionally been central to the functioning of the U.S. securities markets, namely: (i) trading; (ii) clearance and settlement; (iii) order routing; (iv) market data; (v) market regulation; and (vi) market surveillance.15 SCI systems include all computer, network, electronic, technical, automated, or similar systems of, or operated by or on behalf of, an SCI entity that, with respect to securities, directly support each of those areas. Any such systems are subject to all of the provisions of Reg SCI except for those systems that are "critical SCI systems."16 As noted below, critical SCI systems are held to higher standards regarding certain Reg SCI requirements.

"Critical SCI systems" directly support functionality related to: (i) clearance and settlement systems of clearing agencies; (ii) openings, re-openings, and closings on primary trading markets; (iii) trading halts; (iv) initial public offerings; (v) the provision of consolidated market data (i.e., SIPs); or (vi) exclusively listed securities. Critical SCI systems also include those systems that provide functionality to the securities markets for which the availability of alternatives is significantly limited or nonexistent and without which there would be a material impact on fair and orderly markets.17 Additionally, "indirect SCI systems" are only subject to the provisions relating to security and intrusions. Indirect SCI systems are only those that are operated by or on behalf of an SCI entity that, if breached, would be reasonably likely to pose a security threat to SCI systems.18

IV. SCI EVENTS

Reg SCI identifies and prescribes specific requirements related to three defined "SCI events": systems disruptions, systems compliance issues, and systems intrusions. In the Proposing Release, the SEC listed certain events as examples of systems disruptions, including: (i) a failure to maintain service-level agreements; (ii) a disruption of normal operations; (iii) a loss of use of any SCI system; (iv) a loss of transaction or clearance and settlement data; (v) significant delays in processing; (vi) a significant diminution of ability to disseminate timely and accurate market data; or (vii) a queuing of data of such duration that normal service delivery is affected.19 The SEC removed these seven specific criteria in the adopted regulation because it believed that the proposed definition was both under-inclusive and over-inclusive.20 Instead, a systems disruption is defined as an event in an SCI entity's SCI systems that disrupts, or significantly degrades, the normal operation of an SCI system.21 A systems compliance issue is "an event at an SCI entity that has caused any SCI system of such entity to operate in a manner that does not comply with the [Exchange] Act and rules and regulations thereunder or the entity's rules or governing documents, as applicable." Significantly, there is no materiality threshold for either a systems disruption or a systems compliance issue.

A systems intrusion is any unauthorized entry into any SCI system or indirect SCI system of an SCI entity. The SEC intends, with this definition, to cover any unauthorized entry into SCI systems or indirect SCI systems, regardless of the identity of the person committing the intrusion (whether outsiders, employees, or agents of the SCI entity), and regardless of whether or not the intrusion was part of a cyber attack, potential criminal activity, or other unauthorized attempt to retrieve, manipulate, or destroy data, or access or disrupt systems of SCI entities.22 The definition does not include unsuccessful attempts at unauthorized entry. There is also no materiality threshold for a systems intrusion. Given the definition's unqualified inclusion of any unauthorized access by any person, potential SCI entities should establish comprehensive and effective monitoring policies and procedures related to SCI systems in order to detect and investigate potentially unauthorized access of those systems. These policies and procedures should account for not only attacks and intrusions by outsiders, but also access of SCI systems by unauthorized employees. Further, SCI entities should develop comprehensive training programs related to SCI-systems access for both authorized and unauthorized employees.

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Footnotes

1. See Regulation Systems Compliance and Integrity, Securities Exchange Act Release No. 34-73639 (Nov. 19, 2014) (to be codified at 17 C.F.R. §§ 242.1000-1007) (hereinafter, the "Adopting Release").

2. See Adopting Release at 444. As of the publication of this article, the Adopting Release has not yet been published in the Federal Register.

3. See Securities Exchange Act Release No. 69077 (March 8, 2013), 78 Fed. Reg. 18084 (March 25, 2013) (hereinafter, the "Proposing Release").

4. The ARP was established by the SEC's two policy statements, each titled "Automated Systems of Self-Regulatory Organizations," issued in 1989 and 1991. See Securities Exchange Act Release Nos. 27445 (November 16, 1989), 54 FR 48703 (November 24, 1989) and 29185 (May 9, 1991), 56 FR 22490 (May 15, 1991).

5. 17 C.F.R. § 242.301(b)(6). See also Securities Exchange Act Release No. 40760 (December 8, 1998), 63 FR 70844 (December 22, 1998).

6. Rule 1000.

7. See Adopting Release at 27.

8. See id. at 33-34. Entities excepted from the definition of an SCI SRO are the National Futures Association and securities futures exchanges. See id. at 33 n.78.

9. See id. at 39, 54-57, 66-67; Rule 1000.

10. Based on data collected from ATSs pursuant to FINRA Rule 4552 for 18 weeks of trading in 2014. See id. at 55.

11. See id. at 39.

12. The definition includes processors of the CTA Plan, CQS Plan, Nasdaq UTP Plan, and OPRA Plan. See id. at 73 n.196.

13. E.g., Omgeo Matching Services - US, LLC.

14. Rule 1000.

15. The SEC has limited SCI systems to include only those systems relating to market regulation and market surveillance rather than all regulation and surveillance systems (e.g., systems relating to dispute resolution or capital requirements). See Adopting Release at 89.

16. See id. at 79.

17. This last prong of the definition is a "catch-all provision" designed to account for further technology advancements and the continual evolution of the securities markets. The SEC stated that it was not aware of any SCI systems that would satisfy this prong of the definition at the time of the publication of the Adopting Release. See id. at 105-06.

18. The definition of "indirect SCI systems" does not include any systems of an SCI entity for which the SCI entity establishes reasonably designed and effective controls that result in SCI systems being logically or physically separated from such non-SCI systems. See id. at 111. References to "indirect SCI systems" are included in the definitions of "responsible SCI personnel," "SCI review," and "systems intrusion" in adopted Rule 1000. Rule 1001(a), requiring reasonably designed policies and procedures to ensure operational capability, applies to indirect SCI systems only for purposes of security standards. In addition, Rule 1002, which relates to an SCI entity's obligations with regard to SCI events, applies to indirect SCI systems only with respect to systems intrusions. Further, pursuant to Rule 1003(a), the obligations related to systems changes apply to material changes to the security of indirect SCI systems. In addition, the requirements regarding an SCI review apply to indirect SCI systems. See id. at 113-14.

19. See id. at 124-25.

20. See id. at 125.

21. A system is disrupted when its normal operation is halted. A system is degraded when its performance and functionality suffers (e.g., data queuing or slowing of response times). See id. at 125, 126 n.384.

22. See id. at 140-41.

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