Direct market access

Regulatory straightjacket for naked sponsored access - Aite

Regulation that defines minimum risk requirements and standardises sponsored access arrangements is likely to hit US and European equity market participants in 2010, according to Aite Group.

The research consultancy’s latest paper, ‘Sponsored Access: Where the naked need not apply’, predicts that the new rules will be particularly focused on so-called naked sponsored access, which involves no day-to-day pre-trade risk monitoring by the sponsoring broker.

Sponsored access allows firms that are not members of exchanges to gain access to trading venues using the market participant identification of a member broker-dealer, also known as a sponsoring broker. This is similar to direct market access, although the access infrastructure used by the sponsored participant is not necessarily owned by the sponsoring broker. The study estimates that sponsored access currently accounts for 50% of trading volume in the US equities market.

More conventional ‘filtered’ forms of sponsored access use risk controls and connectivity that are typically provided by third-party vendors or service bureaus recommended by the sponsoring broker. Naked sponsored access however, does not include real-time risk monitoring by the sponsoring broker.

The report notes that the rise of high-frequency trading has led to an increase in the interest shown in sponsored access over recent months because of the latency advantages it provides. Filtered sponsored access allows firms to access markets in 550-750 microseconds, according to Aite, while naked access has the lowest range of latency, from 250-300 microseconds. By comparison, a typical DMA service introduces between four and eight milliseconds.

According to the paper, likely regulatory initiatives may include standardising applications and contractual agreements across market centres, installing uniformed risk checks at market centre level, proposing a minimum set of pre-trade and real-time risk checks that must be conducted by firms accessing markets directly and minimum capital requirements for sponsoring brokers.

"Most major market participants agree that sponsored access arrangements should be standardised in some fashion," said Sang Lee, managing partner with Aite Group and author of the report. "That said, it would be a mistake to think that increasing regulatory oversight on the activities of non-broker-dealers in sponsored access arrangements would eliminate all systemic risk from the institutional trading market. Market participants must continue to monitor systemic risks and focus on truly understanding their customers."