The US financial markets regulator, the Securities and Exchange Commission (SEC), is at last on the brink of voting through legislation that will effectively ban ”naked' or ”unfiltered' sponsored access.
Naked access is the form of direct market access which involves the most minimal support by the broker, usually just a market participant identifier that allows the trading firm to access the market. If the broker supplies pre-trade risk management structures, which have the side-effect of adding latency, access becomes ”filtered' rather than ”naked'. Naked access offers the highest speed access possible for non-broker-dealers but at the cost of sacrificing pre-trade risk management. This has raised fears that large volumes of trading are being carried out with insufficient supervision, but this week the SEC is expected to finally kill the practice off.
The volume of trading carried out under naked access conditions appeared to surprise the US regulators when they discussed it with market participants in late 2009. Indeed representatives from regulatory body the Financial Industry Regulatory Authority (FINRA), formerly the National Association of Securities Dealers (NASD), reportedly believed that notices to members of the New York Stock Exchange and Nasdaq, issued in 2002 and 2004 respectively, had effectively banned naked access. The latter document, for example, insisted that “firms must have in place a supervisory system and written supervisory procedures reasonably designed to ensure that orders are not entered in error or in a manner inconsistent with NASD rules.”
A report released in December 2009 by research firm Aite Group, and cited in the SEC's proposed rule, estimated that 38% of equity trading in the US was performed by naked access. By January 2010, it had become clear that the industry was interpreting market rules in a different manner to the regulators. On 19 January, the SEC proposed rule 15c3-5, ”Risk management controls for brokers or dealers with market access', which would require “brokers or dealers with access to trading directly on an exchange or alternative trading system including those providing sponsored or direct market access to customers or other persons, to implement risk management controls and supervisory procedures”.
The SEC's consideration of whether to adopt the rule will now take place at an open meeting on 3 November 2010. Since it was proposed, the market has experienced a severe shock in the form of the ”flash crash' of 6 May when markets suddenly plummeted and recovered. As a result, the SEC in league with the exchanges is running a pilot programme until 10 December on market-wide system circuit breakers that halt trading if stock move 10% in a five-minute period. SEC chairman Mary Schapiro has said that further shocks have been prevented, noting that, “One of the new, individual stock circuit breakers was triggered when an algorithm attempted to execute 10% of the stock’s average daily volume in two seconds.” In theory, the combination of pre-trade risk management systems and circuit breakers will act as a double layer of protection, making it harder for rogue trades to enter the market, and then preventing large price movements in the case of a normal trade effecting a market shock.
Rule 15c3-5 is being voted on before other proposed rules, such as the large trade reporting system and a ban on flash orders, because of its ”architectural' importance, says Gary LaFever, chief corporate development officer at FTEN, a provider of low-latency pre-trade risk management systems. “The market access rule, combined with circuit breakers truly – not elegantly – prevents a market collapse,” he says. But LaFever points to the lack of a limit on a broker's intraday credit limit and the requirement to calculate clearing deposits based on the previous day's closing position as potential weak spots in the new framework.
High-frequency trading firms that trade large volumes intraday and finish the day without accumulating a position only have to pay the minimum US$10,000 clearing deposit. This means that for a relatively small up-front cost, a trading firm could amass a huge loss on credit from a broker intraday, leaving both the clearer and the broker hugely exposed.
Moreover, not all market observers are convinced that the SEC has identified the right target in its attempts to make the market safer and more robust. “Theoretically it makes sense,” says Sang Lee, founder of Aite Group. “But if you look at all of the major market blow outs they typically occur at fully regulated broker-dealers often in esoteric instruments. I'm not against restricting this activity but its not going to prevent a massive crisis.”
In addition, the SEC is due on 5 November to hold a meeting with the Commodity Futures Trading Commission, the US's derivatives regulator, with which it has joint formed the Advisory Committee on Emerging Regulatory Issues. The meeting will hear a report from its subcommittee into pre-trade risk management, along with a recap of the report into the flash crash which it originally received at the end of September, and a report into cross-market linkages.