A new sponsored access regime is on the way. This will change the relationships between some broker-dealers and their high-frequency customers. The goal is to ensure that broker-dealers have financial and regulatory controls in place to fulfill their regulatory responsibilities when their customers access market centers via a “sponsored” arrangement without first going through the broker’s systems.
In response to the Securities and Exchange 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. Nasdaq formulated its proposal in response to an SEC “term sheet” that outlined important characteristics of a sponsored access rule. 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.” He said his exchange is working on its own rule proposal and would soon submit it 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. Arca’s Draddy noted that “quite a few” member firms at Arca are sponsored by other members. He didn’t comment on non-member firms getting direct sponsored access.
The new rules put 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 passes through the sponsoring broker’s systems before reaching the exchange 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 and not trade products it’s not allowed to trade. 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 that 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.”
Arca’s Draddy agrees that risk management controls are in order. “The SEC,” he said, “is looking for better control over this type of access to the markets and to have everyone be fairly consistent in how they approach [sponsored] access to exchanges.” He added: “It’s better for all exchanges to understand the order flow coming in, and for broker-dealers monitoring this to have some consistency of thought from the exchanges and SEC.”
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.
In Jacobs’ view, one problem with the sponsored access rule proposal is that its stated compliance obligations focus on post-trade reports rather than pre-order-placement validation. “Reg SHO, for instance, says a broker has an affirmative obligation to make sure all orders marked as long sales are indeed long,” he said. “This needs to be done prior to order placement, not after the trade is executed. It’s a black-and-white issue.” In addition, he said, a customer’s true beneficial position is its net position across all market centers, not just one exchange, which is the focus of the current sponsored access rule proposal.
The Lime exec thinks the proposed sponsored access rule shifts attention away from where it’s needed. “The rules that are necessary are clarifications about obligations under Reg SHO and Reg NMS, as well as the Financial Industry Regulatory Authority’s supervisory control requirements,” he said. “These are rules that are not currently being enforced when it comes to direct sponsored access flow.” Jacobs said Lime would like to see consistent enforcement of existing rules and order validation requirements for flow sent directly to a trading center. In his view, that would “shut down the regulatory arbitrage that results when end customers trading under a direct sponsored access arrangement are able to avoid requirements that would otherwise be imposed on them by executing through a broker-dealer’s trading system.”
Sponsored access has been on the SEC’s radar for about two years, as the ways that non-member firms are able to access exchanges have evolved. Erik Sirri, director of the SEC’s Division of Trading and Markets, observed last May at a Security Traders Association conference in Washington, D.C., that “great disparity” exists among various sponsored access arrangements.
“[There are] some models where access is straight through, from the institution right to the exchange, without going through the broker-dealer’s systems,” Sirri said. “Others have models where a service provider steps in the middle between the institution and the exchange.” These differ from the electronic access to exchanges that brokers were already providing to customers through the brokers’ own systems. The SEC official told attendees that some guidance “around controls and broker responsibility” for the trading done by sponsored participants would likely be forthcoming, and that the Commission was in discussions with FINRA as well as market centers about the issue of sponsored access.
The Securities Industry and Financial Markets Association has also pushed for changes involving sponsored access. In a comment letter to the SEC last September, SIFMA said the various rules at NYSE Arca, the New York Stock Exchange, Nasdaq and BATS did not clearly define sponsored access, were not identical, were often interpreted differently and varied in documentation requirements. The industry group said its “principal goal” regarding sponsored access was “to ensure that uniform guidance is provided to members, particularly on regulatory expectations regarding trading oversight, supervision and risk controls.”
