A recent Bloomberg piece that for some reason was made available only to terminal subscribers, provides a very interesting discussion on the dangers of sponsored access, how the associated pre-trade vs post-trade monitoring deliberations by "regulators" will influence short selling curbs, and not surprisingly, the desire by Goldman to not only dominate this yet another aspect of high-frequency trading, but to dictate market policy at will.
What is sponsored access:
In sponsored access, a broker-dealer lends its market participation identification (MPID) number to clients for them to trade on exchanges without going through the broker's trading system, to avoid slowing down the execution. That places responsibility on the broker-dealer to make sure the participant abides by securities regulations, and that its trading, which can involve hundreds or thousands of orders a second, does not run amok.
Is it thus surprising, that none other than Goldman Sachs is muscling its way into providing not only a sponsored access platform to its clients, but a new form of sponsored access that needs the blessing of regulators:
Wall Street heavyweight Goldman Sachs, now launching its own sponsored-access service to lend clients its identification to access securities exchanges directly, said last week it favors monitoring client orders prior to execution.
"Our view is that there is a real need for pre-trade checks in the use of sponsored access to fulfill [broker-dealers'] regulatory responsibilities," said Greg Tusar, managing director at Goldman.
Goldman's stand in favor of pre-trade instead of post-trade monitoring of sponsored clients' activity is one side of a debate in which regulators may choose a middle ground. The regulators' decision on how to monitor sponsored access may also influence their deliberations on restricting short sales.
What is the difference between pre-trade and post-trade monitoring? In brief:
- Compliant with Reg SHO
- Nip problems before they happen
- View activity across exchanges
- Faster order executions
- Pre-trade systems still fallible
And another tidbit:
In traditional sponsored-access arrangements, a broker-dealer determines a client's suitability to access market centers directly and then allows the client to trade without monitoring its individual orders prior to execution.
In other words, the Goldman endorsed pre-trade approach will allow "monitoring of individual orders prior to execution." Whether or not pre-trade checks provide the capacity to observe not just wholesale exchange activity in the context of sponsored access but from a much broader market angle is a discussion for another time, although this could be one place where Sergey Aleynikov could shed an infinite amount of light, especially as pertains to Goldman's sponsored-access service. Conveniently, his gag order will prevent him from saying much if anything until such time as there is an appetizing settlement to keep him gagged in perpetuity. The bottom line is that with a pre-trade environment, the sponsored access providers will be able to have the potential to front run all those who use their platforms. The residual question of how far they go to comply with regulations to prevent this from happening, and remain true to their ethics standards is also a topic for another day.
Going back to the topic at hand. Here is why sponsored access could easily be quite a bother to capital markets sooner rather than later:
Unchecked errors or unintended repeat orders could deplete broker- dealers' capital, and potentially wreak havoc in the broader market. Concerns have arisen, however, about whether all broker-dealers are able to fulfill that duty in today's electronic trading environment, and according to which standards.
And here Goldman chimes in to not only promote their proposed architecture but to expound on the virtues of pre-trade checking.
"In the case of high-frequency trading, in particular guarding against technology failures, oversized orders and other situations where there's potentially systemic market impact, we believe strongly that pre-trade checks are a prerequisite," Tusar says.
Nasdaq's proposal as well as Securities and Exchange Commission officials' speeches a few months ago appeared to lean toward bolstering the traditional approach.
"We don't believe that's strong enough or what the regulators want now, because of the potentially dire consequences, and because we-as broker-dealers-bear much of that risk," Tusar says.
Now the reason why this is very relevant in the context of not just potential front running, but also market structure is that Regulation SHO, which is the primary regulatory framework for short selling (and the purvey of potential Uptick Rule reinstatement, which will happen once the market is allowed to hit a bid) is a post-trade architecture.
Wedbush [Morgan] routinely tests clients' systems to ensure they are compliant with Reg SHO. In addition, he says, the brokerage sets limits on clients available locates-as well as credit and trading limits--before the start of each trading day that its system tracks, prohibiting shorts without locates and providing a type of pre-trade check.
Or as has recently become the case, seeing rolling buy ins in the middle of the day as borrowable shares in even the most liquid stocks mysteriously disappear (look at today's market action for yet another blatant example of this practice). The benefits of seeing major short blocks crossing the tape ahead of other participants are too many to mention.
Anticipating the regulators' likely response, one should not be surprised to see them siding with Goldman and against shorters:
As the SEC also seeks to appease investor concerns over rampant short selling, especially naked short selling, new sponsored-access standards may provide part of the solution. Given that day-traders may be the last remaining culprits of such activity,, increasing and standardizing scrutiny over their trading may reduce uncovered (and illegal) shorts even further.
How about appeasing concerns over rampant, unjustified buying? When will the downtick buy rule be implemented? But we jest.
And I digress again. Why should all this be concerning to advocates of stability of high-frequency trading:
The mother of all concerns is a sponsored firm's algorithm going awry and executing thousands of problematic trades across a range of securities and market centers.
Well, this is not really a problem when it happens to the upside as has been the case for months now - it is only a threat when Joe Sixpack's 401(k) may be impacted, i.e., to the downside.
And here is where a SEC Comment submitted by broker Lime Brokerage is a very troubling must read by all who, with unfathomable naivete, claim that High-frequency trading is a boon to an efficient market (which doesn't provide . Well, yes and no - it is, until such moment that it causes the market to, literally, break. I will post a critical excerpt from the Lime submission, and leave the rest to our readers' independent analysis:
Lime's familiarity with high speed trading allows us to benchmark some of the fastest computer traders on the planet, and we have seen CDT (Computerized Day Trading) order placement rates easily exceed 1,000 orders per second. Should a CDT algorithm go awry, where a large amount of orders are placed erroneously or where the orders should not have passed order validation, the Sponsor will incur a substantial timelag in addressing the issue. From the moment the Sponsor’s representative detects the problem until the time the problematic orders can be addressed by the Sponsor, at least two mintues will have passed. The Sponsor’s only tools to control Sponsored Access flow are to log into the Trading Center’s website (if available), place a phone call to the Trading Center, or call the Sponsee to disable trading and cancel these erroneous orders – all sub-optimal processes which require human intervention. With a two minute delay to cancel these erroneous orders, 120,000 orders could have gone into the market and been executed, even though an order validation problem was detected previously. At 1,000 shares per order and an average price of $20 per share, $2.4 billion of improper trades could be executed in this short timeframe. The sheer volume of activity in a concentrated period of time is extremely disruptive to the process of maintaining a “fair and orderly” market. This shortcoming needs to be addressed if the practice of Naked Access is going to be permitted to continue; otherwise, the next “Long Term Capital” meltdown will happen in a five-minute time period.
And here is the punchline: our wise exchanges and broker-dealers have already set the stage for an outcome that will be extremely disadvantageous to anyone who is not a member of the "club." The strawman is total market collapse (which will happen sooner or later regardless) - just look at this chart from the CME indicating the phenomenal growth in prop trading across clients and the increasing domination of computerized trading:
So in essence the forced choice to regulators and traders by the likes of Goldman and exchanges it the following: pre-trade clearance, i.e., seeing ahead of all trades for entities who use sponsored access, a platform that all will soon need to be used be everyone who wishes to remain competitive in this day and age where one extra milisecond of latency over a long enough timeline renders a speculator (or basically trader, now that "buy and hold" is dead) useless, or the threat of complete market collapse. In other words: do what we want or the repercussions will destroy the free market.
It is time to call the bluff on all these alternatives by the administration and by Wall Street that have the apocalypse as one of the two options.