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May 3, 2010

Will a Naked Access Ban Raise Costs?

By James Ramage

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  • Will a Naked Access Ban Raise Costs?

If the Securities and Exchange Commission's proposal for sponsored access to exchanges becomes a rule as written, then trading costs will likely rise for many market participants.

Dan Weingarten

This, at least, is the conclusion of the largest suppliers of unfiltered, or "naked," sponsored access, a trio of clearing brokers: Wedbush Securities, Penson Financial Services and Fortis Bank Nederland. These firms clear for clients--mainly broker-dealers--who employ high-frequency trading strategies.

Naked access is the practice of providing broker-dealer customer orders low-latency access to the exchanges without first performing pre-trade risk checks on them. The SEC's rule would force all broker-dealer orders to undergo pre-trade risk checks before they reach the exchanges.

At the heart of the rule is adding another pre-trade risk check for compliance at the clearing firms, which would slow down their clients' orders. Most broker-dealers already do pre-trade risk checks for their orders. They don't want to have to go through a second set of these checks when trading through their clearers, said Dan Weingarten, a co-director of global sales and marketing with Penson.

"That obligation is better served at the broker-dealer who refers [the order] to the clearing firm," he said.

Wedbush and Penson have said a rule requiring them to implement pre-trade risk checks on their orders should not apply to them, because their clients already perform such checks.

To avoid running their orders through two sets of risk checks, the clearing firms' broker-dealer customers would access the markets directly, rather than by using the clearer market participant identifiers. That would allow them to keep their latency down, but they would lose the benefits of aggregated volume that the clearers provide. Going it alone would mean paying higher take fees and receiving lower rebates. In other words, the economics of trading worsen.

The comment period for the proposal ended in March. Exactly 34 letters were sent to the SEC. Most in the industry favor the proposal's position that unfiltered sponsored access should be abolished. Chances for its passage are high, and that decision could come any day.

Still, those firms that provide naked access, such as Wedbush and Penson, were dead set against a rule. They said that such a proposal would increase costs for their broker-dealer customers and the markets at large.

The reason for such a rule is that the SEC and others in the industry fear that an unsupervised account without proper safeguards could blow up the market. The concern is that if a wrong keystroke is accidentally entered, or a high-frequency trading firm doesn't have the proper credit, trades won't clear.

Goldman Sachs, for example, supports the SEC's stance on risk checks. "We agree with the commission that risk management controls should be under the control of the broker-dealer sponsoring such access," Goldman wrote.