Sponsored Access: Should Trades Be Monitored Before They're Made?
October 5, 2009
Nasdaq's top 10 maintainers of trading activity are mostly the biggest of brand-name broker-dealers. But Wedbush Morgan Securities, a regional firm based in Los Angeles, has topped its liquidity provider rankings since March 2006.
Wedbush's high volume of buying and selling stems from its insight early in this decade that traders would want faster execution speed and lower fees, as automation would allow higher frequency trading. As Nasdaq's top liquidity provider, it presumably is executing at least 95 million shares daily on average to capture the exchange's most attractive pricing tier.
However, Wedbush's ability to surpass the likes of UBS, Morgan Stanley and Goldman Sachs in lubricating Nasdaq's electronic market also reflects its willingness to give high-frequency customers direct and fast access to the exchanges. It aggregates their orders under its own market participant IDs, allowing those traders unimpeded access to the exchanges under the Wedbush name - and ultimately the firm's capital umbrella - even though they may not be regulated exchange members.
"In the race to get to the market first, you're more likely to win that race if you do it with fewer checks," says Sam Lek, who heads up Lek Securities, a self-clearing broker-dealer that caters to professional traders.
Jeff Bell, vice president at Wedbush says that 95% of the firm's order flow stems from high-frequency traders, and most of that arrives at the exchanges through sponsored-access arrangements.
If orders aren't carefully monitored, there is the risk that a customer's trades could go awry. An algorithm running amok is a big concern, for instance. This could result in market havoc, albeit unintentionally.
Wedbush watches its customers carefully, a split second after the trade is made.
The riskiest form of sponsored access to markets, say rivals, is "naked access,'' where the customer's order flow is not subject to any evaluation or monitoring of risks before execution. But Wedbush, Penson Worldwide and Genesis Securities - all of whom perform risk checks immediately after a trade is made-have not had any significant problems with sponsored traders.
Fueling concerns about sponsored access is the lack of regulatory standards for just how broker-dealers should monitor their customers' activity.
Some standards may come soon. Nasdaq proposed rules in January that would inform the exchange who broker-dealers' sponsored clients are and impose contractual obligations among all three parties on covering positions, if, for instance, a client can't come up with shares or cash when needed. If approved by the Securities and Exchange Commission, it would apply to all the exchanges.
The proposal, however, does not address a key issue roiling brokers and regulators: should customers' order flow be monitored prior to execution, or is monitoring it a split second after an execution sufficient?
That question gains importance as the volume of orders executed through sponsored-access arrangements grows.
Westborough, MA-based Tabb Group estimates high-frequency trading desks generated 60% of all equities trading and 70% of orders in the first half of the year - significant numbers even if cut in half.
There are many variations of high-frequency trading and not all these traders' orders go through sponsored-access arrangements. But there are enough to prompt two of the biggest names on Wall Street, UBS and Citigroup, to launch sponsored-access programs in the near future.
