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
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<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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