SEC Intends To Prohibit Naked Access, Seeks Public Comment
First flash, now naked access. While we are certain those whole livelihood depends on scalping and manipulating markets and finding loopholes from regulation will scream bloody murder (look at the industry response to suggestions that HFT is "evil") will provide some very vocal public comments, at least the SEC implicitly acknowledges that naked access is not quite the boon to investors that Goldman et al would like to make it seem.
For once we applaud the SEC in this endeavor. Of course, once the SEC ends the public comment solicitation period with "no action", or a ruling that does nothing at all to change the actual naked access process, we will resume our daily calls for Mary Schapiro's immediate resignation.
The following is the text of an SEC fact sheet:
The Securities and Exchange Commission will consider proposing a rule that would effectively prohibit broker-dealers from providing customers with "unfiltered" or "naked" access to an exchange or alternative trading system (ATS).
It would also require brokers with market access, including those that sponsor customers' access to an exchange, to put in place risk management controls and supervisory procedures. Among other things, the procedures would help prevent erroneous orders, ensure compliance with regulatory requirements, and enforce pre-set credit or capital thresholds.
Market Access by Broker-Dealers
Broker-dealers are required to comply with the rules of the exchanges to which they have access. Using their special pass,' known as the market participant identifier or MPID, they can electronically
access an exchange or ATS and place an order for a customer.
Broker-dealers are specially regulated with respect to their access on an exchange or ATS because they are subject to the federal securities laws as well as the rules of the self-regulatory organizations that regulate their operation.
Customers Placing Orders Themselves
Today, most orders are routed for execution in milliseconds through high-speed, high-volume, automated algorithmic trading. High-frequency trading alone has been estimated to account for more than 60 percent of the U.S. equities market volume. As a result, some sophisticated
customers particularly institutions have begun using technological tools to place orders and execute high-speed trades themselves. They do so by essentially bypassing their broker-dealer, who provides the customer with the MPID.
When the customer is provided with access to an exchange or ATS using the broker-dealer's MPID, the arrangement is known as "direct market access" or "sponsored access."
In some of these arrangements, the customer is able to place an order that flows directly into the markets without first passing through the broker-dealer's systems and without being pre-screened by the broker-dealer in any manner. This type of direct market access arrangement is known as "unfiltered" access and "naked" access.
A recent report has estimated that naked access accounts for 38 percent of the daily volume for equities traded in the U.S. markets.
Regardless of the type of market access, the broker-dealer who provides the access is legally responsible for all trading activity that occurs under the MPID.
The Potential Concerns Associated with Sponsored Access:
There have already been signals of the dangers posed by not maintaining effective risk management controls for sponsored access. For example, it was reported that, on September 30, 2008, trading in a listed stock became extremely volatile toward the end of the day, dropping 93% in value at one point, due to an influx of erroneous orders onto an exchange from a single market participant operating through a sponsored access arrangement. As a result, numerous trades had to be canceled and the stock's closing price had to be adjusted.
Through sponsored access, especially "unfiltered" or "naked" sponsored access arrangements, there is the potential that financial, regulatory and other risks associated with the placement of orders are not being appropriately managed. In particular, there is an increased likelihood that customers will:
* enter erroneous orders as a result of computer malfunction or human error,
* fail to comply with various regulatory requirements, or
* breach a credit or capital limit.
Requirements Under the Proposal:
The proposed rule would require broker-dealers, who are members of an exchange or subscribe to an ATS, to implement certain risk management controls and supervisory procedures to manage the various risks. These controls and supervisory procedures would effectively eliminate "unfiltered" or "naked" sponsored access. Under the proposed rule, a broker-dealer must establish, document and maintain a system of risk management controls and supervisory procedures reasonably designed to manage the financial, regulatory and other risks related to its market access, including access on behalf of sponsored customers. In association with this requirement broker-dealers must:
* create financial risk management controls reasonably designed to prevent the entry of orders that exceed appropriate pre-set credit or capital thresholds, or that appear to be erroneous;
* create regulatory risk management controls reasonably designed to ensure compliance with all regulatory requirements applicable in connection with market access;
* have financial and regulatory risk management controls applied automatically on a pre-trade basis before orders route to an exchange or ATS;
* maintain risk management controls and supervisory procedures under the direct and exclusive control of the broker-dealer with market access; and
* establish, document and maintain a system for regularly reviewing the effectiveness of its risk management controls and for promptly addressing any issues.
The proposal seeks public comment and data on a broad range of issues relating to market access, including the costs and benefits associated with the proposal. After careful review of comments, the Commission will consider what further action to take on the proposal.