Two big broker-dealer and hedge fund groups, concerned about the disruption of one of the Street’s growing trading-related businesses, attacked a proposal by Nasdaq to impose new rules on the practice known as sponsored access.
The Securities Industry and Financial Markets Association filed its grievances with the Securities and Exchange Commission via a letter last Thursday. The Managed Funds Association separately filed its list of complaints last Tuesday. Both letters decry the new requirements Nasdaq has proposed for broker-dealers facilitating sponsored access.
The groups argue that the practice, which involves hedge funds, broker-dealers and others transmitting orders directly to exchanges under the names of their sponsoring brokers, would be irreparably harmed if the SEC approves Nasdaq’s plan. SIFMA wrote that any new framework “should not be so burdensome or unrealistic as to disincentivize the continued evolution of this important business.”
In its 16-page letter, 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.
Sponsored access refers to a broker-dealer member of an exchange (or participant of an ECN) giving other market participants direct access to that market center. Sponsored firms are typically hedge funds, speed-conscious statistical arbitrage firms, or other brokers that make their own trading decisions and enter exchanges under the names of their “sponsoring” brokers. The practice can take the form of sending orders through the broker’s systems, directly to the market center or via a third party such as a technology provider.
According to Nasdaq, 15 percent of its volume comes from “direct sponsored access” and “third-party sponsored access,” in which order flow is sent directly to exchanges using a broker’s market participant ID. Unlike “direct market access” flow, these orders do not pass through the broker-dealer’s systems and are therefore not automatically subjected to the same type of risk controls they otherwise would be.
Nasdaq proposed a sponsored access framework at the SEC’s behest. The SEC for the last two years has expressed repeated concern that orders sent to the market via sponsored access may not get the same type of oversight and risk checks that order flow routed through a broker receives. Nasdaq’s proposal would impose new contractual, financial and regulatory requirements on brokers that want to provide sponsored access to customers. NYSE Arca is working on a rule proposal that’s expected to be similar to Nasdaq’s.
SIFMA, whose constituent firms are mainly broker-dealers, argues that sponsored access would be choked off if Nasdaq’s stringent proposal gets a green light. SIFMA’s letter, written by associate general counsel Ann Vlcek, also notes that broker-dealers have already developed a set of robust best practices for sponsored access–and that Nasdaq would have done better to borrow from that set of rules.
But SIFMA went much further. It argued that the pre-trade and post-trade risk management requirements laid out in Nasdaq’s proposal should be scrapped because they either run counter to the goal of fast sponsored access for firms authorized by brokers to access the markets directly, or because they duplicate existing securities rules that already apply to brokers. SIFMA also said Nasdaq and other exchanges that are commercial for-profit companies should share the risk management burden of brokers through, for example, exchange-level filters for erroneous trades and systems to ensure compliance with trading halts.
In making this suggestion and laying out several other ways in which Nasdaq should bear some of the responsibility for trading activity that comes through sponsored-access arrangements, SIFMA’s letter highlights some of the latent fault lines that run through the shifting relationship between brokers and exchanges. These frictions are likely to deepen as this discussion continues.
The letter fleshes out the complexity of the issue. Even as SIFMA wants more flexibility around sponsored access arrangements, it said that some of its member firms envision a disaster scenario in which unchecked sponsored access could harm the integrity of the markets. SIFMA appealed to Nasdaq to remedy the lack of “definitive and tangible constraints” placed on the overall sponsored trading activity that comes through individual sponsoring broker-dealer firms.
A “potential ‘disaster scenario’ would be one (or multiple) Sponsoring Members allowing almost unencumbered trading activity and market access, thereby accumulating significant counterparty exposures to the sponsoring exchanges well in excess of their risk capacity,” the SIFMA letter said. “Under such a scenario, were a significant amount of these trades to fail, the sponsoring exchanges and, by extension, the overall market, may be left with significant financial exposures that could adversely impact all trading activity in the market.” SIFMA said Nasdaq should step up and provide brokers with guidelines for “counterparty-specific and enterprise-wide credit and risk controls in the context of sponsored access.”
The response of another industry group has exposed other fault lines in the trading business. The Managed Funds Association, an industry trade group that represents hedge funds, funds of funds and other alternative investment vehicles, stressed its concern about the “broad authority” Nasdaq’s proposal grants brokers to examine a customer’s books and records. In particular, it doesn’t want brokers pulling back the covers and peeking at the proprietary trading activity of their sponsored access clients.
“We are particularly concerned that employees of a Sponsoring Member’s proprietary trading division could access and misuse Trade Data to front-run a Sponsored Participant’s trades or to reverse engineer its trading strategy,” MFA’s letter to the SEC said. The MFA said it would like to see limitations on the scope of the data that sponsoring members could demand, along with limitations on who could access that data and how it could be used.
And that’s not all. The MFA wants sponsoring brokers to “certify” they will maintain information barriers to protect customer information, and it wants the SEC, FINRA and Nasdaq to be able to “audit these procedures.”
In underscoring these fears, the MFA also took a couple of swipes at Nasdaq. It said Nasdaq could use the requirements in its sponsored access framework to push its own commercial exchange-level risk management products. In addition, if Nasdaq has access to the “highly proprietary trading information” of sponsored firms, the trade group said, the SEC should audit the safeguards and controls that Nasdaq puts in place to ensure that proprietary trading information is used only for regulatory purposes. Nasdaq declined to comment for this article.
