By this time next year, the potentially risky practice of naked access is likely to be verboten. A year ago, Nasdaq OMX Group proposed a rule redrawing the obligations for member firms granting clients various forms of direct trading access to the Nasdaq market. Debate about the proposed "sponsored access" rule ran all year, with the Securities and Exchange Commission announcing in October that it would add a "Commission-level" rule to what Nasdaq is working on. That proposal, to be issued next year, will address naked access in particular.
Sponsored access is a trading relationship whereby a broker-dealer uses its market participant identifier to allow a customer to trade directly on an exchange. Those customers can be other brokers or non-broker-dealers. Under some arrangements, a customer’s flow passes through the broker’s systems, while in others it does not. The latter is called "naked" or unfiltered access. Brokers, of course, are responsible for their customers’ order flow regardless of how it reaches the marketplace.
The SEC proposal will tackle two main issues beyond what’s covered in the Nasdaq proposal, David Shillman, associate director of the SEC’s Division of Trading and Markets, said in a November conference sponsored by FIX Protocol Ltd. Both issues involve risk management for orders sent directly to exchanges by non-broker-dealers.
"There are two key issues that deserve focus and that we’ll certainly be focusing on intently as we develop a Commission-level rule," Shillman said. "The first is: Should the risk controls be pre-trade, before the order is entered on the exchange? And the second question is: Who controls the controls?"
Regarding the latter, he said, the issue is whether the risk management controls should be under the exclusive control of the broker-dealer, rather than the firm receiving sponsored access. Shillman said the Commission staff began working on the proposal in October.
The focus on sponsored access is driven by the growth of high-frequency trading and technology developments. Some of the non-broker high-frequency players use sponsored-access arrangements to reach the markets. According to the SEC, at least half of U.S. equities volume involves high-frequency trading.
"Given the increasing concerns about sponsored access and the fact that it’s grown so dramatically, we’re starting to feel a sense of urgency that we wrap things up and assure that there is an effective rule in place uniformly across the markets," Shillman said. The SEC’s proposal, he added, will build on Nasdaq’s proposal.
In December 2008, Nasdaq, at the SEC’s behest, proposed a new rule for sponsored access. The SEC’s goal was to "come up with a uniform rule that sets a minimum baseline standard of minimum financial and regulatory controls for those offering the service," Shillman said. He said Nasdaq "stepped up earlier this year and filed a model rule in which many of those concerns are identified." Industry participants expect copycat versions of any rule approved for Nasdaq to be adopted by all the other exchanges to ensure consistency in sponsored-access arrangements across market centers.
Nasdaq’s proposal is likely to be approved in the near future. At the FPL conference, Jeffrey Davis, deputy general counsel at Nasdaq OMX Group, said that Nasdaq "filed what we think is the final amendment" to its sponsored-access proposal on Oct. 23. That amendment was 54 pages.
Changes to sponsored access have been a long time coming. The SEC has talked about the importance to tackling this for at least a couple of years. The Securities Industry and Financial Markets Association told the SEC earlier this year that "unencumbered trading activity and market access" could result in a "potential ‘disaster scenario’" that could harm brokers, exchanges and the marketplace generally. Lime Brokerage has been a fierce critic of certain forms of sponsored access, arguing, for instance, that surveillance for Regulation SHO violations is impossible if order flow does not pass through various risk filters before reaching a market center. Lime says that can’t be done after the fact.
Goldman Sachs, Morgan Stanley, Credit Suisse and other big banks have also criticized naked access this past year. In their view, the risks associated with unfiltered access are too great. Broker-dealers, they say, cannot perform all the oversight functions necessary without imposing some risk checks on clients’ order flow.
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