Regulators Target 'Naked' Access

R.A. Hettinga rah at shipwright.com
Tue Oct 13 06:07:12 PDT 2009


Once again "transparency" shits on privacy's back, to paraphrase Ben  
Franklin.


Cheers,
RAH
--------


<http://online.wsj.com/article/SB125539101215281471.html?mod=djemITP#printMode 
 >

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.





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