The industry got some needed breathing room. The Securities and Exchange Commission decided in late June to postpone compliance with a cornerstone of its sponsored-access rule for four months. That gives broker-dealers time to figure out how to build credit checks into their businesses that serve high-frequency traders.
Broker-dealers engaged in a sponsored-access business now have until Nov. 30 to comply with the section of SEC Rule 15c3-5 that requires them to establish credit thresholds for their customers. All other parts of the rule dealing with the trading of equities, ETFs, options and swaps went into effect on July 14.
On that date, brokers became responsible for policing their customers’ activities on an order-by-order basis. Come November, they must be able to set overarching trading limits on a customer-by-customer basis. They must also be able to manage their aggregate customer exposure across the firm.
As of July, brokers have to check each order to make sure it complies with the SEC’s rules and those of the self-regulatory organizations. They also have to make sure the orders are not “erroneous.” Erroneous orders are those with incorrect quantities or prices or those that are “duplicative,” or entered twice.
Checking for duplicative orders has proved challenging, but for the most part brokers have had little trouble instituting risk checks to guard against regulatory breaches or simple erroneous trades. Most have been running these checks for years.
The requirement that sponsoring brokers establish credit, or trading, limits for their customers, on the other hand, has proved taxing for many. Although some have always incorporated trading limits into their electronic platforms, many have not.
Traditionally, brokers have relied on assurances from their customers that they would not exceed certain limits. Plus, industry rules give customers three (previously seven) days to settle their trades. Any problems get dealt with during the settlement process.
“Some firms were able to deal with the issue of trading limits on a customer-by-customer basis,” said Michael O’Conor, a consultant with Jordan & Jordan. “Others were only prepared to deal with it on a firmwide basis. “Now everyone must do it on a customer-by-customer basis.”
Behind the new rule are SEC concerns over brokers offering “naked,” or unfiltered, sponsored access to high-frequency traders. The practice of “renting” a broker’s name to an HFT unencumbered by risk checks previously constituted the majority of sponsored access.
Behind the credit checks are SEC concerns over the ability of high-frequency traders to build up outsize positions in seconds. Assuming an HFT is able to trade 1,000 orders per second, the SEC estimated a high-frequency shop could build up a position of $720 million in only two minutes. “Financial exposure through rapid order entry can occur very quickly,” the regulator intoned in its final ruling, issued last November. The regulator’s stated aim is to protect the sponsoring broker and any trade counterparties from financial harm, and to prevent disruptive market behavior.
The work being done by brokers to comply with this aspect of the sponsored access rule is considerable. It involves discussions between staffers of several related departments, as well as systems work. Then the broker must perform quality assurance testing to make sure the new checks “don’t impact anything else,” O’Conor said.
The new credit check rules “represent a fundamental shift in the way the majority of our industry performs risk management,” Manisha Kimmel, an executive director with the Financial Information Forum, told the SEC in a letter. “Significant analysis is required to determine the policies and procedures that will in turn be codified into new and existing systems.”
The biggest challenge is the technology, O’Conor noted. Some firms have systems that may be readily adaptable. Others don’t. Those with legacy, homegrown systems may be at a disadvantage, the exec points out.
They may be at a disadvantage from a competitive perspective as well, according to the chief executive of a brokerage that has offered filtered sponsored access for years. “This is a huge technological challenge,” said Sam Lek, head of Lek Securities.
Once the brokerage determines a client’s trading limit, it must apportion that limit to all the exchanges and dark pools it provides that customer access to. On top of that, the broker must be able to adjust those per-venue limits on the fly. That is difficult to do, Lek said, without slowing down the customer’s trading.
The standard methodology would be to require the customer to send the order to the firm; perform the credit check; and then route the order to the venue. The disadvantage is that doing that imposes an additional “hop” between the customer and the exchange.
To eliminate that hop, Lek has set up a system whereby the order is sent directly to a co-location server at the exchange and the order information is asynchronously routed to a central location. There, it is checked against predetermined credit limits. The step adds “only a few nanoseconds of latency” to the process, Lek said.
“I don’t think anyone on the Street is capable of accomplishing this,” Lek said. “You need a fairly complex system of connectivity.”
Adding to the complexities of compliance is the SEC’s insistence that the amount of a trader’s credit limit be calculated based on open orders and not executions. Some brokers, including Goldman Sachs, argued that trades were a better gauge of exposure. That’s because some trading strategies employ a large number of orders, but cancel a high percentage of them.
In a letter, the New York chapter of the Security Traders Association told the SEC that “checking inbound orders alone without taking into account the effect of executions and cancellation rates could adversely affect market liquidity, transparency and price discovery.”
The SEC still maintains that orders are the appropriate basis for calculating credit exposure because of the ability of HFTs to quickly build up exposure. But it granted brokers some leeway. Rule 15c3-5 permits brokers to “discount” those open orders that are unlikely to execute.
While brokers appreciate the flexibility, it is still a chore to calculate that discount. Brokers must arrive at statistical representations of their clients’ trading to predict how much credit to extend the trader on any given day. O’Conor noted that all his clients “are using historical data to establish those trading limits.”
Lek Securities has been doing this for years, according to its head man. The firm does an “instantaneous stress test” to determine the likelihood that all the open orders will execute. “You cannot ignore open orders,” Sam Lek said. “But you can provide a reasonably scientifically founded discount of credit-based open orders.”
