Once again "transparency" shits on privacy's back, to paraphrase Ben Franklin. Cheers, RAH -------- <http://online.wsj.com/article/SB125539101215281471.html?mod=djemITP#printMod...
The Wall Street Journal OCTOBER 13, 2009 Regulators Target 'Naked' Access Concerns Over Risk Management of Anonymous, High-Speed Trades By SCOTT PATTERSON Federal securities regulators are examining whether an arrangement that lets high-speed traders rapidly buy and sell large chunks of stock anonymously could go awry and threaten markets. Called sponsored or "naked" access, the setup allows high-speed firms and other outfits to trade directly on exchanges using powerful computers without the exchanges or regulators knowing who is making the trades. "We understand that some firms are offering so-called naked access without effective controls over financial regulatory risk," said David Shillman, associate director of the Securities and Exchange Commission's division of trading and markets, which is stepping up its scrutiny of the issue. The practice is one of several involving high-frequency trading that is troubling regulators amid a broader look at making securities markets more transparent and stable. High-frequency firms collectively trade billions of shares a day using computer algorithms to capture fleeting changes in prices. The strategy recently has been one of the most lucrative in the markets and now accounts for more than half of stock-trading volume, according to industry estimates. Sponsored access is akin to members of an exclusive club charging others to use their pass. The members in this case are registered brokerage firms that are approved and pay to trade on exchanges. High- frequency firms or other traders such as hedge funds cut deals with these regulated brokerage firms that let them use their computer access codes -- known as a "market participant ID" -- to trade directly on exchange computers that match buy and sell orders. Stock exchanges are usually left in the dark about the identity of the trading firms, and only see trade orders in the name of the sponsoring broker. Still, exchanges and brokerages have supported the practice, which brings in huge trading volumes and fees. One concern, regulators say, is that a trading outfit could suffer a massive loss through a computer glitch that threatens the financial stability of the sponsoring broker, or triggers a sudden and unexplained decline in the broader market. Brokers that provide sponsored access are on the hook for client losses that exceed the client's capital. "The risk is that neither the broker nor the exchange have any obligation to implement technology that would allow them to act" if a cascade of rapid-fire orders went awry, potentially destabilizing markets, said Laurie Berke, a principal with Tabb Group, which tracks computerized trading. Defenders of sponsored access note that so far there has been scant evidence that the arrangements pose risk to markets. They say brokerage firms employ rapid posttrade checks that can quickly shut down an operation if orders run amok. They also say high-speed traders are sophisticated enough to avoid problems. For now, a patchwork of loose rules among exchanges and brokers governs the practice. The SEC says naked access poses threats to stability, whereas "flash orders," a type of high-speed trading that recently has caught the attention of politicians, raise concerns of fairness. Flash involves some traders getting a sneak peek at market orders before other investors. The SEC has recently sought to ban flash orders. Sponsored access has spread in recent years along with high-speed trading. On the Nasdaq Stock Market, the biggest volume provider is Los Angeles-based Wedbush Securities, a closely held brokerage firm with more than $2 billion in assets, according to the Nasdaq. Wedbush says more than 75% of the volume in its clearing unit stems from traders using sponsored access. Goldman Sachs Group Inc. and Credit Suisse Group AG provide a variant of sponsored access, according to representatives at the firms. But, unlike Wedbush, they require the firms to route orders through their computer systems before the orders go the exchange; this step creates a more-immediate way to monitor trades. Citigroup Inc. says it doesn't provide the service but is considering offering a version in the future. Trading outfits that use the service say that if they had to channel orders through a brokerage firm's computer systems, the resulting split-second delays could put them at a disadvantage to rivals who trade directly on the exchange. Sponsored access, they say, is cheaper than paying the costs involved with becoming a brokerage firm and paying for the exchange access. Critics fear sponsored-access risk-management standards are slipping, and risks are rising, thanks to the increased volume of high-frequency trading, ramped up speeds, and because of the difficulty regulators and exchanges face keeping up with traders' technological advances. Though sponsored access has been on the SEC's radar for more than a year, the agency's concerns lately have mounted as more firms jump into the field of high-frequency trading, according to a person familiar with the agency's thinking. In January, Nasdaq OMX Group Inc., which runs the Nasdaq Stock Market, submitted a proposal to the SEC with new sponsored-access rules. In late September, the Nasdaq submitted an updated proposal and is waiting for feedback. The SEC is concerned the exchanges haven't enacted new rules quickly enough, according to a person familiar with the matter. Another concern is that the exchanges could face conflicts of interest, since they benefit from the huge volumes high-speed traders bring to the market. If the exchanges don't act soon, the SEC may impose its own rules, the person says. Though the SEC isn't expected to impose a ban, it could require that users of sponsored access submit to pre-trade order checks monitored by the brokerage firm. The rule would undercut the practice by curbing the speed advantages firms get from sponsored access. One example of a bad trade this year in a transaction similar to sponsored access highlights how complex trading systems in high-speed markets can break down. SWS Group Inc., a Dallas financial-services firm that "clears," or processes, trades for clients, suffered a $6.3 million pretax loss when a client's trade went awry. The client traded past certain limits and was "ignoring our repeated attempts to contact," SWS Chief Executive Donald Hultgren said on an August earnings call. Earlier this decade, Wedbush slashed fees it charged clients to boost volume. High-frequency firms piled in, including via sponsored access. One recent Wedbush sponsored-access client is Quadeye Trading LLC, a New York high-frequency-trading firm with $10 million in capital. Quadeye is run by four traders with a background in computer-driven mathematical investment strategies, including Sudeep Gupta, who has more than a decade of experience working on quantitative trading desks at Morgan Stanley and Merrill Lynch, now part of Bank of America Corp. Mr. Gupta says the firm has "multiple layers of risk control." Wedbush, which declines to share revenue figures or a sponsored-access fee schedule, says firms using sponsored access and brokerage firms that offer it are motivated to manage their risk, since even small glitches can result in big losses that the brokerage firm ultimately could have to bear. "We think the risk decisions should be left to the people with the capital on the line," said Jeff Bell, an executive vice president at Wedbush. Mr. Bell says Wedbush hasn't incurred any losses from sponsored access. He says sponsored access allows more traders to compete in the high- frequency race, which adds liquidity to markets that can help generate price competition. Wedbush has proposed the Depository Trust & Clearing Corp. as a vehicle for risk-management checks for traders using sponsored access. As for less-sophisticated traders entering the high-frequency race, "we have a history of weeding those folks out," said Mr. Bell.