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News January 18, 2010 Issue

SEC Throws a Robe on Naked Access

The scandal hasnít happened yet, and the SEC isnít waiting around for it, either.

For years now, certain sophisticated traders have been bypassing their broker-dealers to transact business directly in the marketplace. Using the brokerís unique id number, clients can engage in high frequency trading and other risky practices that are evaluated only after-the-fact by any regulated supervisory system or controls. This "naked" (a/k/a "sponsored" or "unfiltered") access trading has mushroomed in recent years, according to a report by the Aite Group, to represent 38 percent of the daily trading volume in the U.S. equity markets.

Naked access has been a handy little gap in regulation that has served hedge funds and other large institutional investors well. With their own computers and trading algorithms at work directly in a marketplace, these clients enjoy an advantage over others while the broker remains responsible for all trading activity that occurs under its identifying number.

No more, however, if the new rule proposed by the SEC in a January 13 open meeting is adopted.

"We must be vigilant," said SEC Chairman Mary Schapiro, "in identifying and addressing emerging risks to investors, broker-dealers, and the integrity of our markets." Naked access increases the risk of mismanaged orders, breaches of credit or capital limits, and compliance failures, she said.

She described danger signals in a late 2008 incident where such direct trading produced a series of erroneous orders that resulted in the near-complete devaluation of a companyís security. The error had to be corrected through numerous trade cancellations and an adjustment of the stockís closing price. Permitting direct access trading to continue, said Schapiro, would increase the likelihood of these erroneous orders, that customers will fail to comply with various regulatory requirements, and that they might breach a credit or capital limit.

Proposed Rule 15c3-5 would close the existing regulatory gap and effectively prohibit naked access, she said. Under the proposed rule, broker-dealers would implement "effective pre-trade risk management controls and supervisory procedures" that ensure all trading is gated and subject to supervision.

Speaking metaphorically, Schapiro said brokers should no longer be allowed to give their keys to these "unlicensed drivers" and wave good-bye as they roar off unaccompanied down the road. "Todayís proposal," she said, "would, in short, require that if a broker-dealer is going to loan his keys, he not only must remain in the car, but he must also see to it that the person driving observes the rules before the car is ever put into drive."

Hereís what traders will face if the rule is adopted as proposed:

Order flow only through registered broker-dealers that implement

  • Risk management controls applied on a pre-trade basis and supervisory procedures under the direct and exclusive control of the broker-dealer with market access;
  • Controls designed to prevent the entry of orders over pre-set credit or capital thresholds, or that appear to be erroneous; and
  • Controls that ensure compliance with all market access requirements.

The broker must also review its controls, document the effectiveness of those controls (including annual certifications), and promptly address any issues that arise.

At the open meeting, the public got its first look at new Division of Trading and Markets Director Robert Cook. Reliance on customer self-compliance is an insufficient mechanism to ensure market integrity, he said. A more comprehensive approach, one that would remain with the broker and not be outsourced, was necessary. Under the proposed rule, all controls must remain under the direct supervision of the broker and only pre-trained and appropriately authorized personnel would have access to the brokerís trading system.

Commissioner Kathleen Casey said the ruleís required controls appear at first blush to be a defensible approach. She worried, however, about the possibility of "rushing to regulate." She noted that the public comment process offered the staff an opportunity to develop a better understanding of the entire marketplace.

"Sometimes we donít know what we donít know," she said, "and the spectre of an unintended consequence looms large."

Commissioner Luis Aguilar agreed that the regulator should do no harm. However, he said, it is just as important that "we not be timid, and do what has to be done."

Taking a "whack-a-mole" approach may pop up other problems, Casey observed. Vigorous competition for customer order flow has produced benefits in the marketplace, and it is imperative not to impede or reverse this considerable progress, she said.

The release focuses on risk, she observed. So how reliable is the data indicating that 38 percent of the equity markets trade through a naked access relationship? Henry Hu, director of the Division of Risk, Strategy and Financial Innovation, allowed that the staff had no way to verify the specific number cited in the report. However, he said, it is fair to say the trading represents a material percentage of the marketplace, a percentage that the Commission should be concerned about.

Casey then noted that the proposal includes proprietary trading activity. What concerns prompted that inclusion? Cook said that the concern is establishing consistent, appropriate controls across the board to address an identified risk. Cook and other members of his team acknowledged that in many cases, brokers that do not offer sponsored access have controls in place already that substantially comply with the rule proposal.

Commissioner Elisse Walter observed that the proposed rule would only apply to brokers or dealers with access to an exchange or alternative trading system. In the scenario in which non broker-dealers offer sponsored access to an alternative trading system, for example, the ATS would not be covered under the proposal. She asked about the impact of not including ATS subscribers within the reach of the rule. "We donít know exactly," said one member of Cookís team. It is a gap, he acknowledged, but not one the staff believed to be a major gap. ATSs represent a relatively small number of market participants, and the vast majority of players would be captured under the current rule proposal, he said.

Walter strongly supported the rule proposal as bringing order to the "patchwork" of SRO oversight rules, and leveling the playing field. Walter recognized and appreciated SRO efforts at rulemaking in this area, but said that the SEC must supplement those efforts as only it can. Without this regulation, she said, certain trading restrictions can be overlooked, and anything from "fat finger" errors to intentional trading fraud can topple market participants and trigger a market destabilizing domino effect.

Walter asked if the risk control standards being offered in the proposal were sufficiently clear, or whether additional, more specific controls should be implemented, such as specific standards for capital controls. Cook responded that the staff sought to strike a balance in the proposal and to recognize that different models might require different approaches. "If we try to define the mousetrap too specifically, we may prevent somebody from building a better mousetrap," he said.

Walter also asked how the SEC proposal compares with SRO rules, including a very recently approved Nasdaq rule. Cook acknowledged many similarities to the Nasdaq rule, which was a "significant step in right direction." The SEC rule would apply across markets, however, and would preclude outsourcing oversight functions, which may be permitted in the Nasdaq rule. Nasdaqís effort, he noted, does advance the ball.

Commissioner Troy Paredes asked the staff about a "driving concern" of the proposal, systemic risk potential. What would have to be the chain of events to actually result in a systemic risk?

Fortunately to date, events have not risen to a systemic level, responded one staffer. "We think that alone justifies the rule proposal." Algorithms out there produce trades in milliseconds. Errors there could cause quite a bit of damage, and could get into the millions of dollars quite quickly, he said. Exchanges have erroneous trade rules, but that would not capture all potential problems. Orders also spread rapidly throughout markets that would not be large enough to trigger any one exchangeís thresholds, but could result in significant consequences to the trader. "We want to be proactive to ensure these events donít occur."