Securities and Exchange Commission concern over high-frequency traders accessing the markets under their brokers’ names, but not through the trading systems of those brokers, will soon be addressed through a new “sponsored access” regime. The goal is to ensure that broker-dealers have financial and regulatory controls in place to fulfill their regulatory responsibilities.
In response to the Commission’s desire to create a framework around sponsored access, Nasdaq recently filed a proposal that lays out a series of requirements for member firms that provide sponsored access to customers. Those customers can include institutions as well as other broker-dealers. The exchange’s proposed rule fleshes out Nasdaq’s existing rule set around sponsored access.
“The definition of sponsored access is something the SEC is focused on: direct market access vs. direct sponsored access vs. third-party access,” said Brian Hyndman, senior vice president for transaction services at Nasdaq OMX Group. “There will be financial, regulatory and risk management controls put in place in the new sponsored access rules.”
James Draddy, chief regulatory officer at NYSE Arca, said Nasdaq’s filing “makes a lot of sense.” Last month, he said his exchange would submit it to its ownrule proposal to the SEC.
Sponsored access refers generally to a broker-dealer member of an exchange providing other market participants with access to that market center. This type of access has existed for several years through brokers’ DMA platforms as well as through more-direct access into exchanges, but the requirements around sponsored access have been amorphous and the rules have been different across market centers.
Another concern with sponsored access is that competition for flow from high-frequency trading firms and other customers bent on low-latency access to the markets could be driving some brokers to relax their supervisory controls. This regulatory worry is compounded by the lack of clear definition for sponsored access and the variety of arrangements now in place.
According to Nasdaq’s Hyndman, a number of Nasdaq broker-dealer members currently provide direct sponsored access to customers. “It’s a small percentage of our overall customer base, but it could be in excess of 15 percent of our overall volume,” he said.
The new rules impose more definition around the types of sponsored access arrangements that currently exist. Nasdaq’s new rules and contractual requirements will apply to direct sponsored access, in which a sponsoring broker provides the sponsored participant with technology to reach the exchange directly, and third-party sponsored access, in which a service bureau or third party, such as Lava Trading, FTEN or FlexTrade Systems, provides the technology to access exchanges via an arrangement with the sponsoring broker. DMA is considered different from the two other forms of sponsored access since a customer’s DMA flow first passes through the sponsoring broker’s systems and is therefore already subject to financial and regulatory controls and checks.
Among other requirements, the new rules obligate the sponsored firm to abide by the sponsoring member’s credit and financial limits. In addition, the sponsoring broker must maintain controls to ensure compliance with rules related to short selling, trading halts and prohibitions against manipulative trading practices.
These rules are designed to ensure that brokers, who are legally responsible for their customers’ orders and compliance with various trading and market rules, maintain supervisory control over that activity. “When orders do not come through a broker-dealer’s pipes, the broker’s obligation to review the order flow is the same as when customers come through the broker’s pipes,” Arca’s Draddy observed.
The expectation is that an eventual sponsored access rule will formally articulate this responsibility through a contractual agreement. “This will be an agreement between the sponsoring broker-dealer and the sponsored participant,” said Hyndman of Nasdaq. “The SEC is saying you need to have some risk management in place. Some firms already have it, and what they have might be a sufficient mechanism. Other firms may need to do more.”
But not everyone is enthusiastic about the proposed sponsored access rule. John Jacobs, director of operations at Lime Brokerage, believes Nasdaq’s proposal raises important sponsored access points “at a high level,” but doesn’t adequately frame a broker’s responsibility to ensure that its clients are complying with regulatory rules such as Regulation SHO. He said his firm, which provides fast DMA to hedge funds, broker-dealers and automated trading firms, worries that this rule will be seen as supplanting, rather than echoing, a broker’s existing supervisory obligations.
