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Lime and Lek Rail Against Naked Access
Traders Magazine Online News, July 2, 2009
A pair of direct market access providers registered complaints with the Securities and Exchange Commission over the practices of some of their competitors. Lime Brokerage and Lek Securities, which offer customers direct access to market centers, recently sent letters to the SEC complaining that naked access is a bad practice.
Lime on Wednesday told the SEC that naked access could enable the activity of customers that flout regulatory requirements around short selling to go undetected. "Regulation SHO obligations are impossible to meet under many, if not most, naked-access structures," John Jacobs, Lime's chief operations officer, informed the SEC. These obligations, which are imposed on broker-dealers, require pre-trade real-time compliance checks on customers' flow to ensure compliance, but that can't be done when customers send flow directly to markets without passing through the broker's filters, Jacobs said.
Naked access refers to direct access by non-broker-dealers to market centers, without prior risk checks on that order flow being conducted by the broker-dealer sponsoring that access. Some industry participants note that this type of access can be managed by rigorous due diligence and monitoring by the sponsoring brokers.
Both Lime and Lek argued to the SEC that naked access, which Lek calls "unfiltered access," is used by non-broker-dealers to gain unfair sub-millisecond speed advantages over other market participants that subject their flow to pre-trade compliance filters. This unfiltered access should be banned by the SEC, they said.
Lek pointed out that a significant tradeoff exists between speed and risk controls. "Any [risk] control, including controls in the sponsored participant's own computer system, slow down the process and make it less likely that the trader will win the [speed] race to the market," Samuel Lek, the firm's founder, told the SEC. "Thus there is a perverse incentive to eliminate all checks and balances." This is aggravated, he said, by the fact that some of the firms getting naked access are "unregulated entities" that lie outside the jurisdiction of self-regulatory organizations and the SEC.
The issue of sponsored access to markets has gained attention in the wake of a proposal by Nasdaq, earlier this year, to impose new requirements around various types of sponsored access to its market. Naked access represents some of the trading activity that falls under one of three types of sponsored access outlined by Nasdaq. The SEC had a hand in helping craft Nasdaq's proposal. Any new rule set around sponsored access to Nasdaq would likely be replicated by other market centers.
Naked access is particularly controversial because a sponsored customer's flow gets fast direct access to trading centers without passing through the pipes of the broker or a third-party technology vendor such as an execution management system, and the flow also bypasses various pre-trade risk checks. Lime and technology firm FTEN Inc. have been outspoken critics of this type of sponsored access. However, Penson Financial Services and several other clearing firms have taken a different view. Penson, the third-largest clearing firm in the U.S., told the SEC that while sponsored-access arrangements should be uniform across exchanges, there is no need for new regulations.
In a comment letter in February, Penson said "many of the proposed controls [in the Nasdaq rule filing] are unnecessary, unrealistic, onerous and inflexible." Penson instead favors industry guidance and voluntary controls by broker-dealers, based on their regulatory, financial and risk management needs.
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