A pair of direct market access providers registered complaints with the Securities and Exchange Commission over the practices of some of their competitors. Lime Brokerage and Lek Securities, which offer customers direct access to market centers, recently sent letters to the SEC complaining that naked access is a bad practice.
Lime on Wednesday told the SEC that naked access could enable the activity of customers that flout regulatory requirements around short selling to go undetected. "Regulation SHO obligations are impossible to meet under many, if not most, naked-access structures," John Jacobs, Lime’s chief operations officer, informed the SEC. These obligations, which are imposed on broker-dealers, require pre-trade real-time compliance checks on customers’ flow to ensure compliance, but that can’t be done when customers send flow directly to markets without passing through the broker’s filters, Jacobs said.
Naked access refers to direct access by non-broker-dealers to market centers, without prior risk checks on that order flow being conducted by the broker-dealer sponsoring that access. Some industry participants note that this type of access can be managed by rigorous due diligence and monitoring by the sponsoring brokers.
Both Lime and Lek argued to the SEC that naked access, which Lek calls "unfiltered access," is used by non-broker-dealers to gain unfair sub-millisecond speed advantages over other market participants that subject their flow to pre-trade compliance filters. This unfiltered access should be banned by the SEC, they said.
Lek pointed out that a significant tradeoff exists between speed and risk controls. "Any [risk] control, including controls in the sponsored participant’s own computer system, slow down the process and make it less likely that the trader will win the [speed] race to the market," Samuel Lek, the firm’s founder, told the SEC. "Thus there is a perverse incentive to eliminate all checks and balances." This is aggravated, he said, by the fact that some of the firms getting naked access are "unregulated entities" that lie outside the jurisdiction of self-regulatory organizations and the SEC.
The issue of sponsored access to markets has gained attention in the wake of a proposal by Nasdaq, earlier this year, to impose new requirements around various types of sponsored access to its market. Naked access represents some of the trading activity that falls under one of three types of sponsored access outlined by Nasdaq. The SEC had a hand in helping craft Nasdaq’s proposal. Any new rule set around sponsored access to Nasdaq would likely be replicated by other market centers.
Naked access is particularly controversial because a sponsored customer’s flow gets fast direct access to trading centers without passing through the pipes of the broker or a third-party technology vendor such as an execution management system, and the flow also bypasses various pre-trade risk checks. Lime and technology firm FTEN Inc. have been outspoken critics of this type of sponsored access. However, Penson Financial Services and several other clearing firms have taken a different view. Penson, the third-largest clearing firm in the U.S., told the SEC that while sponsored-access arrangements should be uniform across exchanges, there is no need for new regulations.
In a comment letter in February, Penson said "many of the proposed controls [in the Nasdaq rule filing] are unnecessary, unrealistic, onerous and inflexible." Penson instead favors industry guidance and voluntary controls by broker-dealers, based on their regulatory, financial and risk management needs.
The Securities Industry and Financial Markets Association, for its part, took a two-pronged approach. It noted in February that broker-dealers offering sponsored access typically run rigorous due-diligence checks on firms they sponsor to ascertain that the firm’s financial, technology and risk infrastructures are up to snuff in the broker’s view. But SIFMA also noted that a problem originating with a sponsored-access client whose access to the markets is unfiltered could result in a "disaster scenario" that potentially jeopardizes the existence of the sponsoring broker-dealer as well as the financial health of other market participants.
For some in the industry, the worry is that a problem caused by a single sponsored-access client could reverberate rapidly through the markets. That raises systemic risk concerns. James Brigagliano, the SEC’s co-acting head of the Division of Trading and Markets, said in a speech in May that risks associated with unfiltered access to the markets "can affect many of the participants in a market structure, including the trader’s broker, the exchanges, and the clearing entities. Ultimately, the risks can affect the integrity of the market structure itself."
There is no agreement among market participants that naked access should be outlawed. But even among firms that consider it harmful and that say it should be banned, the solutions recommended can fuel their own separate controversy.
Lek Securities last month suggested that the SEC decapitate the intense focus on sub-millisecond speed that drives some sponsored firms to engage in trading behavior that is potentially risky to the broader marketplace. Lek said the Commission could do this by eliminating time priority for orders received by a market center within the same one-second time period.
"The Commission has already limited the granularity of price priority by banning sub-penny pricing," Samuel Lek, Lek’s founder, told the SEC in a mid-June comment letter. "The Commission should likewise limit the granularity of time priority by treating orders received within a single second as being received at the same time."
The firm went even further: "The Commission should limit the number of orders/cancellations that a single beneficial owner can sent to an exchange in a single symbol on the same side of the market to one per second, and require that all orders received within one second be considered received at the same time and be placed on parity." In Lek’s view, this would make unfiltered access to market centers unnecessary.
This is a radical proposal, given the centrality of price-time priority in the equities markets. High-frequency trading, which typically depends on sub-millisecond trading, also represents the majority of equities volume. According to TABB Group, more than 70 percent of the market’s volume comes from firms engaged in high-frequency trading strategies. A subset of this group receives sponsored access to the markets, and a subset of that group has unfiltered access to the markets.
Joseph Saluzzi, co-head of equity trading at Themis Trading, an institutional agency broker, told Traders Magazine that Lek’s time-priority suggestion "gets us heading in the right direction." In Saluzzi’s view, eliminating the advantages of sub-millisecond speed would benefit the market. He added that he’s glad to hear broker-dealers speaking out against sponsored-access arrangements that involve non-broker-dealers.
"High-frequency traders do not add value to the market," Saluzzi said. "They trade to earn rebates because that’s their business model, but it just muddies the water and creates noise. The volume they add is not real liquidity because their volume can disappear in an instant." He suggests that the SEC should impose a minimum time that orders must be posted for them to gain time priority and earn transaction rebates from market centers.
John Jacobs, chief operations officer at Lime, disagrees with the idea of curtailing sub-second time priority for high-frequency traders and others. "We think that is crazy since these days more than half of all trading is high-frequency-based, and one second is just an eternity," Jacobs said. "For the majority of flow, 50 microseconds [50 millionths of a second] is very material. One second is a timeframe that ignores more than 50 percent of the flow in the market." In his view, unfiltered access should simply be banned.
