Gloves Off
Industry Fights Over Sponsored Access to Markets
Traders Magazine, April 2009
Nasdaq may not have been angling for a fight, but it got one. The exchange, in January, proposed to overhaul its rules about how high-frequency hedge funds and others access its market. Nasdaq feared that orders from some firms with direct high-speed access to its exchange might not be passing through sufficient oversight and risk management checks. More broadly, the worry is that bad or problematic orders that aren't properly monitored could cause disruptions in the market.
The practice now under the lens is called "sponsored access." This mundane-sounding term refers to arrangements by broker-dealers that enable select market participants to fire off orders directly to exchanges, subject to various compliance, credit and risk constraints, with minimal latency and without passing through the broker's infrastructure. Nasdaq proposed its new rules to try to ensure that sponsored-access order flow sent to its market gets treatment similar to the rest of Nasdaq's incoming order flow.
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But sponsored access has become a profitable niche within the brokerage business. And those in this growing business don't want Nasdaq or other exchanges putting the kibosh on what they do.
The industry's response, via comment letters to the Securities and Exchange Commission, has ranged from mild criticism to scathing rebuke. For broker-dealers, Nasdaq's proposed rules represent an effort to impose controls around the way they interact with and oversee their customers.
Vendors don't want businesses that have grown handsomely jeopardized by new rules. Hedge funds and statistical-arbitrage funds aren't happy because new rules could mean additional latency in getting their orders to market. Meanwhile, those with secretive strategies fear exposure if their brokers eye their flow before the orders are sent to the market.
"This is a shot across the bow," said Scott Harrison, CEO of agency broker UNX. "This is an issue the industry needs to talk about. A lot of structural changes are occurring in the trading industry right now, and it's happening without a broad discussion about the long-term impact. It's time to look at it in detail."
The Securities Industry and Financial Markets Association, whose constituent firms are mainly broker-dealers, issued a strongly worded 16-page letter to the SEC arguing that Nasdaq's proposal could sound the death knell for sponsored access, which it said has become an important business that adds liquidity to the markets. SIFMA urged the SEC, the Financial Industry Regulatory Authority and the exchanges to "convene a meeting" with industry representatives to discuss the proposal before any action is taken.
New Framework
Sponsored access refers generally to various types of direct exchange access granted to market participants by exchange member firms. The member firms of exchanges (and participants on ECNs) must, by law, be broker-dealers. Sponsored firms can be brokers, including exchange members, as well as institutions such as high-frequency trading firms and statistical arbitrage shops for whom speed is critical. All trading on exchanges has always been, and remains, the responsibility of the sponsoring broker whose name is on the ticket.
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