SEC's "Naked" Proposal May Hurt Small Dealers
January 25, 2010
The Securities andExchange Commission posted proposed rules Wednesday that would require all broker-dealers to apply pre-trade risk checks on any orders-for customers or their own accounts-executed over market centers to which they provide access.
That came as a relief to some firms, including smaller ones, which provide unfiltered or "naked" access to high-frequency traders. Such a rule would establish risk-management standards that ultimately fortify their firms' capital against trading mishaps.
But there may be a downside as well. The SEC also proposes that broker-dealers control their risk management systems in-house, rather than outsourcing the risk controls to a third party, such as another broker-dealer. That could up execution costs for smaller broker-dealers and reduce their ability to compete against the biggest Wall Street firms, whose huge execution volumes already give them pricing advantages at the market centers.
"From recent conversations I've had, the largest high-frequency trading firms view this [proposal] as a non-issue, because they're already broker-dealers" and comply with existing risk-related rules," says Sang Lee, managing partner at Boston-based Aite Group. Lee adds, "It's probably good for them, because it could potentially slow down some of their smaller competitors."
Sponsored access occurs when a dealer or member of a market rents out its market participant identifier (MPID) to clients, so they can access and trade on an exchange or electronic communication network (ECN) directly. Customers using direct market access send those orders through their broker-dealers' trading systems, which include risk-management checks.
Checks, however, take time, and even though the latency involved is measured in microseconds, that extra time can mean losing the advantage to high-frequency competitors. Risk checks can add anywhere from 10 or 20 microseconds to several milliseconds to the time it takes to send out an order.
Competition has led some broker-dealers to allow unregulated customers to use their own trading systems and pre- and post-trade risk checks, avoiding the broker's own systems and checks. This strategy to further cut latency results in so-called naked access.
Naked access also occurs when clearing brokers such as Penson Worldwide and Wedbush Morgan lend out their market IDs to regulated broker-dealers-some clearing customers and others simply execution customers-to aggregate their order volume, without the clearer performing pre-trade checks.
That approach avoids latency imposed by the clearer's risk system-although the clearer's capital is at risk if trades go awry-while the higher aggregated volumes capture pricing advantages at the market centers.
The SEC's proposal would stop those practices, requiring "the controls be applied on an automated, pre-trade basis before orders are routed to an exchange or ATS, thereby effectively prohibiting the practice of 'unfiltered' or 'naked' access...," the proposal says. The proposed rule applies to trading in all securities, including options, exchange-traded funds and fixed-income, and it applies to broker-dealers' proprietary and traditional agency trading.
Pre-trade checks have been heavily promoted by major Wall Street firms such as Goldman Sachs and Merrill Lynch, as well as direct-market-access providers such as Lime Brokerage. They say a rule is necessary to create a level playing field by setting a minimum standard for risk management.
The proposed rule, however, may upset exchange-fee topography. The biggest Wall Street firms generate high volumes of executions through their proprietary trading desks and their agency-brokerage businesses in addition to their high-frequency customers. Their high volumes make them eligible for significant exchange-fee discounts when they execute market orders and marketable limit orders, and for higher rebates for executing limit orders-taking vs. providing liquidity.
