Proposals by the US Securities and Exchange Commission (SEC) to abolish so-called naked sponsored access could, if enacted, result in an overhaul of brokers’ market access systems and business models, according to market participants.
Naked or unfiltered sponsored access refers to a practice whereby a broker’s client may trade directly on an exchange using a broker’s trading ID without passing through its risk management checks. This differs from standard sponsored access, where the risk controls are present, and direct market access, where orders pass through brokers’ systems. The service is typically used by high-frequency firms to avoid the latency added by broker platforms and checks.
At an open meeting last Wednesday, the SEC unveiled plans to halt the practice with rules requiring brokers to apply financial and regulatory risk management controls to orders on a pre-trade basis before routing to the relevant exchange or alternative trading system. The SEC argues naked sponsored access creates the potential for the inappropriate management of financial, regulatory and other risks associated with the placement of orders. SEC chairman Mary Schapiro likened the practice to a driver giving his car keys to an unlicensed friend and letting him drive unaccompanied.
Some believe the SEC’s planned rule could push a new form of ‘super-DMA’ to the fore, that would aim to incorporate the checks deployed by DMA with more sponsored access-type speeds.
“We have been exploring how to get the risk controls into a slimmed-down format that can be co-located with the exchange and the client, so the client goes through this system before they get to the exchange,” said a source at one global broker, which currently only offers standard DMA. “That could be something everyone has to deliver.”
He added that “a significant amount of systems changes will be needed” as current providers of naked sponsored access adapt to a more conservative regulatory environment.
One example of a super-DMA system is the Chi-Velocity product launched by pan-European multilateral trading facility (MTF) Chi-X Europe last October. Dubbed ‘sponsored direct market access’, the Chi-X solution incorporates a risk management layer that is hosted next to the MTF’s matching engine and which the broker can licence.
Ted Myerson, CEO of FTEN, a firm that develops high-frequency execution and risk management platforms that enable brokers to offer clients sponsored access, believes the new rule could give sell-side firms more opportunity to differentiate. Previously, brokers would simply lend their clients their trading ID. However, the new SEC requirements could allow firms to compete on the speed and compliance of the risk management layer of the service.
“If everyone has to have the extra hop, it is going to come down to how sophisticated you can make it while still meeting and potentially even exceeding the risk controls you are going to need to add to your trading environment,” said Myerson.
The new sponsored access requirements could prove a headache for small and mid-sized high-frequency firms. Paul Zubulake, senior analyst at research and consulting firm Aite Group, estimates that the top seven to 10 high-frequency firms in the US have already anticipated the change by registering as broker-dealers and so will suffer little impact on their trading speeds.
“The major issue is really going to be for the mid-to-small high-frequency trading groups,” he said. They will either have to become broker-dealers themselves, potentially forfeiting the cheaper execution they enjoyed via their sponsoring broker’s volume discounts, or suffer slower execution times as a result of the new controls.
Equally, the brokers offering naked sponsored access to smaller firms could suffer, argued Zubulake. “It will not put them out of business, but it would change their business model.”
The SEC has launched a 60-day comment period, in which it is seeking public opinion and data on a broad range of market access issues, including the costs and benefits associated with its proposed rule.