CAT Compliance Ramps Up on Sell Side with Interfirm Linkages

No one could have predicted that Wall Street’s top compliance project would go into production during a pandemic.  The securities industry is submitting data to the Consolidated Audit Trail, a long-delayed database for tracking the lifecycle of orders and transactions for U.S. listed and over-the counter equites and options in one place.

Even though sell-side operations, compliance, and technology teams have been scattered due to remote work during the pandemic, that hasn’t stopped CAT from moving full speed ahead.

After a delayed start allowed by the Securities and Exchange Commission due to COVID-19, U.S. broker dealers went live with the first phase of CAT reporting for U.S. equities on June 22 (known as phase 2a) and went into production with simple options on July 22 (in phase 2b).

Now broker-dealers are working on “interfirm linkages” in what’s known as phase 2c, slated to go live on Oct. 26, and exchange/Trade Reporting Facility (TRF) linkages which is also going into live production the same day.  Next, brokers and their third-party vendors will code their systems so-called “representative orders” and allocations for equities which go live on April 26, 2021.   Then firms will report on complex options activity – where an option is linked to an underlying equity – by December of 2021.  The last phase of CAT will go live on July 11, 2022 with customer and account information (CAIS).

While adhering to the CAT reporting timeline, sell-side firms are responsible for monitoring the CAT Reporter Portal and for fixing errors and rejects that come back from the Financial Industry Regulatory Authority (FINRA). So far, experts say the industry is doing very well with their data submissions.

“For the most part, for everything that is live in production, the error rates, lateness rates are low,” said Chris Montagnino, Managing Director of Compliance Services at Jordan & Jordan, a certified reporting agent for CAT. “As far as the initial rollout, the data, the integrity checks, the lateness, the intra-firm linkage within a [sell-side] firm, those numbers are all down, which is good,” said Montagnino.

According to the CAT NMS Plan’s September 17 monthly implementation report, of the 1,700 broker-dealers eligible for CAT reporting, 1,224 broker firms have reported to CAT for equities with 13.6 billion messages vs 730 firms with 1.6 billion messages for options.  The average daily lateness rate was 1.09% for equities vs. 2.88% for options, while the average daily reject rate for equities was .64% and .45% for options.

Firms will have to go into the CAT reporter portal to rectify the rejections.  “They can repair a handful and manually fix the various fields or they an submit a file of corrections and mark them with the relevant information,” explained Montagnino.

Under CAT rules, firms have until T+3 to correct the rejects or errors, whereas it used to be T+5 under OATs, he said.

According to FINOPs Report  in “CAT FINRA’s Exams, Deadlines Won’t Be a Virtual Breeze: ”Brokers actually have less than 72 hours because “FINRA doesn’t  provide feedback on any errors until 12 pm EST on T+1 and firms don’t have to report trades until 8 am on T+1.”

But error rates could escalate as the industry tackles more thorny order events and submits higher volumes of data. “All firms need is a few mistakes each day and within a few weeks the backlog of errors could easily become too difficult to fix quickly,” wrote FinOps report.

Keeping the error rates below a certain threshold is a precondition for retiring the incumbent Order Audit Trail System (OATS). Until that point, firms must report to OATS in parallel with CAT.  In a rule filing on Aug. 26, 2020, FINRA proposed that member firms reporting to CAT must sustain an error rate of 5% or less on a submitted basis (precorrections) and 2% or less for post-corrections over the course of 180 days.

To learn about the history of the Consolidated Audit Trail and how the huge compliance project got to this point, read our previous blog, “CAT: Moving the Ball Forward.”

The Big Picture

All of this is happening against the backdrop of regulators demanding more transparency into the trail of orders.  Even though the industry had OATs, regulators did not have all the order de tails to reconstruct market events like the Flash Crash on May 6, 2010.

“FINRA and CAT developed this CAT audit trail to be able to pull up any spoofing or illegal trading activity, whereas they couldn’t do that in OATs,” said David Chu, Vice President of OMS Product management at FlexTrade Systems.  “OATS is limited (to equities) and the SEC couldn’t piece together all that information. With CAT they will have all the OATs events, market making, options, allocations, firm designated IDs or FDIDs. OATS never had this concept,” said Chu, which submits reports to FINRA on behalf of clients using ColorPalette OMS and is a certified CAT reporting agent.

CAT Exams

One of the key motivations for compliance are upcoming CAT exams, which began in the second half of 2020. “Every client’s No. 1 priority is CAT,” said Anthony Melillo, Vice President, Product/Project Management, Sell-Side Solutions at FlexTrade. “Compliance will always be more of a priority than a software enhancement request, or business as usual request,” said Melillo who is leading the CAT compliance effort for clients using FlexOMS.

“Auditors are going to ask the broker-dealers if they have policies and procedures in place to make sure that the data that is being submitted to FINRA CAT is accurate and that there is no under reporting,” said FlexTrade’s Chu.  The CAT exams will occur more frequently – once a month – whereas OATs exams were conducted on a trimester basis.

Examiners could also ask what a firm’s policy and procedure is for setting up a client. “How quickly do you set the client up. What times do you generate your CAT file every day,” said Melillo.

It’s unclear whether these exams are targeted for CAT, or whether they are baked into FINRA’s annual trading desk review, noted Montagnino.

Unlike the CAT report cards, where  statistics are automatically generated from the portal’s perspective  on orders accepted, rejects, and errors,  a CAT exam- either on-site or virtual – is more extensive and could sample data on orders and executions over a longer period of time, said Melillo.

FINRA may inquire about the member firm’s series-24 license holder who is going to supervise that these data files are accurate and ensure there is no under reporting, said Chu.  Examiners are expected to compare the CAT records with the OATS reports. “If they look in OATS and see that  the firm reported an order and route for the client, but in CAT there is a new order and no route, then the auditors will ask why didn’t the firm report another route event in CAT?,” said Chu.

Examiners will look for discrepancies between OATS and CAT and could ding their clients on it. “It’s very important that industry members do their due diligence and check their books-and- records for what is reported to OATS vs what is reported to CAT,” said Chu.

Next on CAT’s Agenda: Interfirm Linkages

As of Oct. 26, sell-side firms will be accountable for reporting “interfirm linkages”, regarded as one of the more complex parts of CAT. “This is where the industry expected to see problems,” said Montagnino.  “The error rates there are a bit higher”, he noted.

FINRA opened the CAT portal on Aug. 10 for data validation of interfirm linkages to give firms two-to-three months to match with counterparties. “All of a sudden interfirm linkage errors were popping up on the CAT portal, and firms were not sure why,” said Melillo.  Even though interfirm linkages were not going live until Oct. 26, FINRA expects firms to fix the linkage errors as soon as possible,” he said.  “Some firms route thousands of order a day, so the volume of errors was getting worse,” said Melillo. That is why when interfirm linkages were first rolled out in test mode on Aug. 10, FINRA saw a high mismatch rate of 40%.  This included routing to another floor broker or to another broker-dealer, said Chu. But over the last month, people have been working with tier counterparties and have reduced the errors to 20%, said Chu.

To reduce the percentage of unmatched rates, FINRA CAT advised firms (via the Sept. 15 implementation report) to focus on communication with counterparties on the linkage keys.  Linkage keys contain pieces of information including the IMID_ industry member ID.

Up until this point, “only intra-firm orders were considered a CAT reportable event,” said Melillo. But now if a broker routes to another broker or an exchange, that is a reportable event.

For example, Montagnino said, if an order is being routed from Goldman Sachs to Bank of America Merrill Lynch, there is a routed order ID, and other pieces of information that make up the linkage key.  “If those don’t match on either side, then there is a break,” he continued. An interfirm linkage issue could arise if one of the brokers receiving an order uses the wrong industry member ID – known as IMID in CAT terms – for the other broker sending the order. “If one side has an issue, then they both have an issue,” said Montagnino.

When a broker receives an order from an institutional client and routes it to a second broker, Chu said then the OMS creates a route event from the first broker to the second broker.  “If we were to link correctly, then the second broker would report a receipt of the order from the first firm and that is how they would link with the routed order ID,” said Chu. However, an interfirm linkage error would occur if the OMS reported an order routing event with a routed ID of ABC, and then the second broker, reports an order accepted event to CAT with an order ID of EFG., he said.

On Oct. 26, broker-dealers’ internal IIT teams or their third-party CAT reporting agents need to fix these linkage errors.  “All errors must be repaired by T+2 or all errors will be considered late,” warned Chu.

“It is the responsibility for clients to look at the CAT web portal,” said Chu.  If there are file submission failures, data ingestion errors or interfirm linkage errors, we have it all automated so they can receive an alert,” he said.

Stay Tuned:  Allocations

Among the heaviest lifts is going to be allocation events linked to underlying orders, which goes live on April 21, 2021. Most sell-side firms are familiar with allocations after there is a parent order or block trade and the executed shares need to be allocated back to hundreds of client subaccounts.  On the other hand, smaller broker-dealers, retail brokers, and proprietary trading firms, send an order out for execution and it goes directly back to the client’s account one for one, he said. “It turns out that CAT wants to see every allocation event for individual trades. If Joe Smith sends and order for 100 shares to his broker, and it gets routed out and executed, and if those shares are booked to an account, regulators want to see an allocation in CAT,” said Montagnino.  “It’s not only the relationship with block orders and sub-accounts, it’s every equity transaction where shares are either executed or sold, requires an allocation event,” said Montagnino.

Representative Orders

Another challenge with 2c involves representative orders that need to be linked to the underlying orders in 2c. “Representative orders are an issue for larger brokers that receive multiple orders from large institutional clients, and they are bunching them together to send out for execution,” said Jordan & Jordan’s Montagnino.

According to a 2019 CAT NMS Plan presentation Equity Representative Orders Deep Dive.  Linkages are required between the customer order and the representative order for the executed or non-executed orders. Executed orders also must have a linkage between the order fulfillment event for the customer order and the representative order from which the fill came.

“While some firms already had to report the linkage of an underlying order to representative orders in phase 2a, so that linkage already exists in their systems, more than likely that didn’t exist and that’s where 2c comes in,” said Montagnino.

Another nuance of CAT in 2c is the requirement to report rejected routes. “If a firm routes an order to a destination/exchange and the destination rejects it back for whatever reason, it has to create a rejected route event. That is unique because it was never required for OATs,” he said.

Since the FINRA test environment for phase 2c opens on January 25 Montagnino said he expects that many firms are already working on allocations, representative orders, and route rejects.

“That’s a big undertaking because you’re talking about a back-office function that never had a post-trade regulatory reporting daily responsibility,” said Montagnino. “They’re not used to these daily processes that have to run every day and need to be tested and validated to show that the reporting is correct.”