Fractions of a second can mean the difference between victory and defeat in many arenas, from the slopes of Vancouver to the world's financial districts. In some instances, medals are at stake, but on Wall Street, the contests can involve millions of dollars.
In today's automated market, order placement rates can exceed 1,000 orders per second with the use of high-speed algorithms. High-speed trading firms use computerized trading systems to exploit small price shifts in trades of billions of shares. The markets have also seen explosive growth in the use of sponsored or direct market access arrangements, where broker-dealers allow customers to trade in those markets electronically using the broker-dealers’ market participant identifiers, or MPID. In these arrangements, as described by the SEC, the broker-dealer allows its customer (which may be a hedge fund, mutual fund, bank or insurance company, an individual, or another broker-dealer) to use the broker-dealer’s MPID or other mechanism to access an exchange or ATS. With “direct market access,” the customer’s orders flow through the broker-dealer’s systems before passing into the markets, while with “sponsored access” the customer’s orders flow directly into the markets without first passing through the broker-dealer’s systems.
Naked access accounts may amount to nearly 40 percent of the daily volume for equities traded in the U.S. markets. The SEC has been concerned that sponsored, or naked, access to the markets, allows the customer to bypass pre-trade risk management controls. The sponsoring broker-dealer could be unaware of the trading activity occurring under its market identifier and have no mechanism to control it. As described by SEC Chairman Mary Schapiro, sponsored access is like "giving your car keys to a friend who doesn't have a license and letting him drive unaccompanied." She stated that order entry errors in this setting could suddenly and significantly make a broker-dealer or other market participants financially vulnerable within mere minutes or seconds due to the lack of pre-trade controls.
It should be noted that the market access concerns involve issues of market stability. This focus differs from that in another area of recent Commission activity, a proposal to end the practice of flash orders. In that release, the SEC addressed the practice of allowing a person who has not publicly displayed a quote to see orders less than a second before the public is given an opportunity to trade with those orders. In this instance, the SEC is primarily concerned with fairness rather than market risk.
In January 2010, the SEC proposed rules that would effectively prohibit unfiltered or naked access arrangements. These proposals would require that brokers or dealers with direct trading access to an exchange or ATS to have a system of risk management controls and supervisory procedures designed to systematically limit the financial exposure of the broker or dealer that could arise as a result of market access, and ensure compliance with all regulatory requirements that are applicable in connection with market access. The proposed rule encompasses trading in all securities on an exchange or ATS, including equities, options, exchange-traded funds, and debt securities.
The controls and procedures would have to include those reasonably designed to prevent the entry of orders that exceed appropriate pre-set credit or capital thresholds, or that appear to be erroneous. The required regulatory risk management controls and supervisory procedures would also have to be geared to prevent the entry of orders without compliance with all pre-order and those which the broker-dealer or customer is restricted from trading. The controls and procedures should also restrict market access technology and systems to authorized persons, and assure appropriate surveillance personnel receive immediate post-trade execution reports.
Comments may be submitted to the SEC through March 29, 2010. Several major participants in this market have not yet commented on the proposals, including two of the most active firms, Penson Financial Services, Inc. and Wedbush Securities. A review of comments submitted by these firms on a similar, but less expansive rulemaking proposal by NASDAQ indicates, however, that these companies will not welcome the SEC proposals.
Jeff Bell of Wedbush stressed the benefits of computerized trading to the markets. He asserted that such trading has significantly increased the liquidity in the markets and reduced the spread between the bid and offer on equities to the benefit of the public and market participants. The competitive nature of this business segment demands, according to Mr. Bell, that these liquidity providers and active traders have the fastest access to the markets possible so they can compete on a level playing field with direct members of the exchanges.
It is essential, according to Wedbush, that the sponsored access rules and obligations of sponsoring members should not be evenly applied to different categories of sponsored participants, such as non-broker-dealers, registered and registered member broker-dealers. The proposed rule does not distinguish between these types of sponsored participants, as it would apply to a customer or any other person who is provided access to an exchange or alternative trading system through use of its market participant identifier or otherwise.
Mr. Bell agreed with the concept that pre-trade risk filters are important to the reduction of risk to the marketplace, but the controls and filters need not be the sole responsibility of the sponsoring broker-dealer, in his view. He described how the firm's sponsored access clients already use high performance risk management systems. He believes that rules requiring these clients to have their orders screened through systems owned and operated by the sponsoring member or by third-party vendors would add considerable latency without a corresponding improvement in risk management.
The exchanges should also continue to improve their technology, said Mr. Bell, so that pre-trade risk filters are available on their platforms for members and sponsored participants alike. Exchange rules should require that sponsored participants and direct members utilize these pre-trade risk filters to reduce risk while establishing a level playing field for all participants. Pre-trade risk filters should be applied to all participants, whether sponsored or not. As stated by Mr. Bell, "to do otherwise would encourage a `race to the bottom' as market participants structure themselves to avoid these important safeguards."
Similarly, Nicole Hamer Williams of Penson Financial Services argued that any change to the current sponsored access regulatory regime should be addressed through the establishment of industry wide best practices that advance the efficient and appropriate regulation of sponsored access. A "one size fits all" approach to sponsored access without regard to the type of participant being sponsored or the practical application of the manner of sponsored access would be unwise, in her view. Non-broker dealers, regulated broker-dealers and NASDAQ members are not all in need of identical controls and procedures, she said.
She agreed with Wedbush that exchanges may be in the best position to develop and implement system wide sponsored access monitoring tools. Exchanges "should be accountable for monitoring and controlling trading activity and should not be allowed to delegate this responsibility to sponsoring members," according to Ms. Williams.
Other commenters view the proposals far more favorably, however. Lek Securities Corporation, a firm that provides direct access to equities, options and futures markets through its ROX electronic order system. According to firm CEO Samuel F. Lek, the SEC proposals are well designed to further an important regulatory goal. Mr. Lek suggested changes, however, to improve the effectiveness of the rule and reduce unnecessary costs.
The rule should cover all securities markets, and not just electronic venues and equity markets. Mr. Lek said there is no justification to exempt the fixed income markets, including the markets for mortgaged backed securities and credit default swaps, from the rule. It should apply, in his view, to any broker dealer that enters into a contractual obligation or otherwise assumes financial responsibility for a securities transaction for its own account or for the account of another person and not solely to exchange members and subscribers to ATS systems.
The rules should also "reduce current incentives to sacrifice compliance for speed." Mr. Lek noted that any credit or compliance checking increases the time for an order to reach the market. Exchange members with direct access to the market for their proprietary orders could have a competitive advantage over non-member broker dealers and customers who have to go through third party checks before their orders reach the exchange. To minimize time pressures and maximize compliance, and to level the playing field, Mr. Lek suggested that the Commission should limit the number of orders or cancellations that a single beneficial owner can send to an exchange in a single symbol on the same side of the market to one per second, and require that all orders received within one second be considered as received at the same time.
Lek Securities agreed with Penson and Wedbush, however, that the rule should continue to permit sponsored access where the person being sponsored is itself an exchange member or ATS participant. Market participants may aggregate their order flow and trading under the mnemonic of a large exchange member to benefit from a lower pricing tier. As currently proposed, Rule 15c3-5 would prohibit an exchange member that uses the mnemonic of another member to reduce trading costs from routing orders directly to the market. There is no regulatory justification for this restriction, said Mr. Lek, because the exchange member is already subject to the rule.
Woodbine Associates, a research and advisory firm, applauded the intent behind the proposal but criticized it for a lack of specifics. According to Woodbine, the proposed pre-trade controls that check orders for anomalous values, share quantities or the number of orders relative to historical trends do not necessarily make sense in the case of certain high frequency strategies. Leaving discretion to brokers to establish baseline controls and procedures is not a desirable approach, stated Woodbine, because it ensures inconsistency across brokers and subjectivity during SEC examinations.
The establishment of controls and procedures for the activities of algorithmic or high-frequency trading firms with naked access "pose a set of challenges that are not solved by basic controls advocated in the proposal." These strategies often involve a large number of orders and may commonly result in large directional positions. Differentiation between intended and erroneous orders might not be as easily detected by basic pre-trade controls, said Woodbine, and this potential shortcoming could be amplified by the consideration that the broker implementing the controls is often not unaware of the details of the strategy.
Leaving brokers to establish baseline risk controls and procedures for naked access clients almost certainly ensures minimal and inadequate risk management,stated the firm. Woodbine urged the Commission to consider a clearly defined, explicit set of baseline operational risk controls and procedures mandated by the SEC to be applied uniformly across brokers providing sponsored access.
The Commission voted unanimously to issue the proposing release. However, the unanimity should not be taken as an indication that the Commissioners are of one mind on the proposal.
Commissioner Kathleen L. Casey expressed some concerns over the "level playing field" language used by some supporters of the measure. She stated that it is no surprise that powerful market participants, and their champions, seek new regulations to create a level playing field. Such requests should be greeted with skepticism, because calls for for a level playing field roughly translate to "I'm losing market share, and need a regulatory advantage," said Ms. Casey. The Commission should develop a deeper understanding of the whole range of U.S. equity market structure issues before adopting any final rule amendments in the market structure space, in her view. Premature action could dampen what she described as vigorous competition for customer order flow among numerous trading venues that has benefited investors.
Commissioner Troy A. Paredes also supported the issuance of the proposal, but noted that he is keenly interested in comments that address how the proposal might impact different trading activities and ultimately market performance. He also will examine costs and benefits of the Commission's proposal as compared to the approach to managing and supervising market access reflected in the Nasdaq rule change noted in the release.
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