Trading TradeOff: When To Monitor Sponsored Access To Exchanges
Errors deplete broker-dealers' capital, wreak havoc in market
July 20, 2009
Wall Street heavyweight Goldman Sachs, now launching its own sponsored-access service to lend clients its identification to access securities exchanges directly, said last week it favors monitoring client orders prior to execution.
"Our view is that there is a real need for pre-trade checks in the use of sponsored access to fulfill [broker-dealers'] regulatory responsibilities," said Greg Tusar, managing director at Goldman.
Goldman's stand in favor of pre-trade instead of post-trade monitoring of sponsored clients' activity is one side of a debate in which regulators may choose a middle ground. The regulators' decision on how to monitor sponsored access may also influence their deliberations on restricting short sales.
Even though it publicly is taking a stance in favor of pre-trade monitoring--which can slow down the execution of trades in high-speed markets where milliseconds count--Goldman has yet to submit a comment letter on Nasdaq's January proposal to standardize sponsored-access arrangements. But Goldman says it has discussed the issue with regulators.
In sponsored access, a broker-dealer lends its market participation identification (MPID) number to clients for them to trade on exchanges without going through the broker's trading system, to avoid slowing down the execution. That places responsibility on the broker-dealer to make sure the participant abides by securities regulations, and that its trading, which can involve hundreds or thousands of orders a second, does not run amok.
Unchecked errors or unintended repeat orders could deplete broker-dealers' capital, and potentially wreak havoc in the broader market. Concerns have arisen, however, about whether all broker-dealers are able to fulfill that duty in today's electronic trading environment, and according to which standards.
"In the case of high-frequency trading, in particular guarding against technology failures, oversized orders and other situations where there's potentially systemic market impact, we believe strongly that pre-trade checks are a prerequisite," Tusar says.
In traditional sponsored-access arrangements, a broker-dealer determines a client's suitability to access market centers directly and then allows the client to trade without monitoring its individual orders prior to execution.
The arrangements have raised concerns about unregulated trading firms accessing market centers without the responsibilities and regulatory oversight applied to broker-dealers. Without those ongoing controls, those firms--especially high-frequency electronic ones--could intentionally or inadvertently execute thousands of problematic orders.
Lime Brokerage, which caters to broker-dealers and hedge funds, notes in a February comment letter that traditional sponsored access undermines proper oversight of markets and their participants, and provides "de facto" exchange membership to non-broker-dealers.
Lime submitted a second comment letter June 30 saying traditional sponsored access also makes compliance with rules such as Regulation SHO, governing short sales, practically impossible. That's because any monitoring would take place after the trade.
"Reg SHO is not a post-trade requirement but an order-placement requirement," says John Jacobs, director of operations of Lime and author of the comment letters.
Nasdaq's proposal as well as Securities and Exchange Commission officials' speeches a few months ago appeared to lean toward bolstering the traditional approach.
"We don't believe that's strong enough or what the regulators want now, because of the potentially dire consequences, and because we--as broker-dealers--bear much of that risk," Tusar says.
