If the Securities and Exchange Commission’s proposal for sponsored access to exchanges becomes a rule as written, then trading costs will likely rise for many market participants.
This, at least, is the conclusion firms with large clearing operations reached in their comment letters to the SEC. These firms clear for clients–mainly broker-dealers–who employ high-frequency trading strategies.
At the heart of the rule is adding another pre-trade risk check for compliance at the clearing firms, which would slow down their clients’ orders. Wedbush Securities and Penson Financial Services have said a rule requiring them to implement pre-trade risk checks on their orders should not apply to them, because their clients already perform such checks.
The comment period for the SEC’s proposal on sponsored access ended in March. Exactly 34 letters were sent to the SEC between Jan. 26 and April 5, expressing their views on the practice. Most in the industry favor the proposal’s position that unfiltered, or "naked," sponsored access should be abolished. Chances for its passage are high and that decision could come any day.
Still, those firms that provide naked access, such as Wedbush, Penson and Fortis Bank Nederland, were dead set against a rule. They said that such a proposal would add costs to their broker-dealer customers, and the markets at large.
The reason for such a rule in the first place is that the SEC and others in the industry fear that an unsupervised account without proper safeguards could blow up the market. The concern is that if a wrong keystroke is accidentally entered, or a high-frequency trading firm doesn’t have the proper credit, trades won’t clear.
Goldman Sachs, for example, supports the SEC’s stance regarding the responsibility for risk checks. "We agree with the Commission that risk management controls should be under the control of the broker-dealer sponsoring such access," Goldman wrote in its March 30 comment letter.
The firm, however, is one of several in the bulge bracket expanding its filtered sponsored access business. It, as well as other B-Ds, could benefit from any measures that would take away from the models the clearing broker-dealers use.
For their part, Wedbush, Penson and Fortis provide their broker-dealer customers access to the exchanges without first performing pre-trade risk checks on their orders. This is the sticking point with regulators. The SEC wants broker-dealers and their clearing firms each to perform pre-trade risk checks, Penson and Wedbush have said.
But the clearing firms say they also provide valuable aggregation services. For these, the clearing firms bundle orders together and send them to an exchange in order to surpass volume thresholds and benefit from better pricing–which gets passed onto clients.
The SEC proposal would make it more difficult for these firms to reach the various volume breakpoints and would eliminate these savings. Forcing, say, Penson to add pre-trade risk checks–on top of the checks its broker-dealer customers already perform–would discourage the customer from using the clearing firm’s market participant identifier to access the exchange, because it would take too long to trade, said Dan Weingarten, a co-director of global sales and marketing with Penson.
"We have a broker-dealer who can access the market directly as a regulated entity, who chooses to go and leverage off the clearing firm give up for efficiencies," Weingarten told Traders Magazine. "And if you remove the ability to do so, you’ve just removed the efficiencies without any added benefit."
And this will be bad for the marketplace and participants alike, wrote Nicole Harner Williams, vice president and associate general counsel for Penson in the firm’s March 29 comment letter. Increased execution costs for investors and the potential decrease in broker-dealers’ abilities to more effectively compete with larger firms will undoubtedly harm such investors and the marketplaces themselves.
"Any cost-benefit analysis of proposed Rule 15c3-5 by the [SEC] should consider the substantial increase to execution costs and the impact of such costs to investors," Williams wrote.
For a firm that doesn’t reach the top pricing tier of a market center and chooses instead to access the markets under their own MPID, they’ll still have to perform the pre-trade risk checks. But that firm would also realize a 32 percent decrease in rebate income, Wedbush wrote.
So, in the best of circumstances, brokers who normally use clearing firms for the tiering benefits have a difficult choice to make, according to Edward Wedbush and Jeff Bell, Wedbush’s president and executive vice president, respectively, in the firm’s March 31 comment letter. Broker-dealers who don’t achieve the best economics from the market centers must choose either slower access to the markets–because of the second set of pre-trade risk checks–or losing the benefit of volume aggregation.
There are other costs, according to Christopher Lee and Paul Willis, global head of market access and global compliance officer, respectively, at Fortis Bank Nederland, in their March 26 comment letter. If the SEC’s proposal is passed as is, there would be a "significant loss of trading volume" among the market participants and proprietary trading firms. And this, subsequently, will have a negative effect on the retail investor volume by reducing overall market liquidity and increase bid-ask spreads, the two wrote. Overall cost-of-trade to the end retail client would rise, they concluded.
In addition, the Wedbush comment letter said the cost estimates in the SEC proposal are too low. They don’t include the hidden costs of becoming a broker-dealer, the impact of additional latency or the loss of economics from volume aggregation. These additional costs far exceed those noted in the SEC’s estimates, Wedbush wrote. Wedbush also calculated that it will cost more than $2 million a year to buy or build the appropriate systems that would add pre-trade risk checks to its sponsored access service.
