SEC to Address Risk Controls in 2010 Sponsored Access Proposal

The Securities and Exchange Commission plans to supplement Nasdaq OMX Group’s current rule proposal concerning sponsored access with an additional Commission-level rule that focuses on risk controls. The SEC’s rule proposal is expected to be issued next year.

David Shillman, associate director in the SEC’s Division of Trading and Markets, said yesterday that the SEC would "build on Nasdaq’s proposal" to address the "mechanics of the [risk] controls" required by broker-dealers offering sponsored access to their customers. Shillman spoke yesterday at a FIX Protocol Ltd. conference on technology and trading in New York.

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. Brokers are responsible for their customers’ order flow regardless of how it reaches the marketplace.

The SEC’s goal has been 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 added that Nasdaq "stepped up earlier this year and filed a model rule in which many of those concerns are identified."

Shillman said Nasdaq’s proposal identified most of the relevant risk management controls that should be addressed. "We’re going to focus primarily on the mechanics of how those controls are applied," he said. "At what point in the order transaction cycle [should the controls be applied], and who has control over the controls?"

The SEC’s latest sponsored access efforts are driven by the growth of high-frequency trading. The SEC has worked with exchanges and the industry on a sponsored access proposal for more than two years. Over that time, Shillman said, high-frequency trading has come to dominate the industry. Many of these firms use sponsored access to trade directly on markets.

"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 told conference attendees. SEC Chairman Mary Schapiro recently directed the agency’s staff to develop a "Commission-level proposal that accomplishes that," he said, adding that "we’ll certainly be building on Nasdaq’s proposal…as we develop that."

Nasdaq’s sponsored access proposal, according to industry participants, is likely to be approved in the near future. At yesterday’s conference, Jeffrey Davis, deputy general counsel at Nasdaq OMX Group, said Nasdaq "filed what we think is the final amendment" to the exchange’s sponsored access proposal on Oct. 23.

In December 2008, Nasdaq proposed a rule outlining various sponsored access arrangements for trading on its market. Once the SEC approves the amended rule, copycat versions are expected to be adopted by all the other exchanges to ensure consistency in sponsored access arrangements across market centers.

The October amendment, which ran to 54 pages, outlined the responsibilities of broker-dealers offering sponsored access to their customers. While the customers may include brokers and non-brokers, the controversial aspects of sponsored access concern what’s called "naked access," or unfiltered access, to an exchange. That refers to trading by non-broker customers whose order flow reaches an exchange directly, without first passing through the sponsoring broker’s risk management checks and filters.

Nasdaq’s Davis said that the industry’s view of naked access is that it "presents unacceptable risks" to the marketplace. Addressing these risks is important, he said.

What the SEC remains concerned about is the specifics of the broker-dealer’s risk controls. The two issues the SEC will focus on are whether broker-dealers must conduct pre-trade risk checks on order flow being sent to the market, and who manages those risk controls.

"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 recently began working on this proposal.