Naked access and flash orders in the spotlight

By Jim Kharouf
With the array of Security and Exchange Commission meetings, congressional hearings, and special committees, Washington pushed ahead with regulatory reforms in January, with an eye on leveling the playing field for investors.

In 2009 and through early 2010, Sen. Charles Schumer (D-N.Y.) and Sen. Ted Kaufman (D-Del.) pushed hard for two key changes to the equity and equity options market regulation. Schumer wants to eliminate flash orders, which in general terms, give certain market makers a “sneak peak” at trader orders and the option to fill them at a better price before they are sent away to another marketplace. Sen. Kaufman has been addressing high-speed access to exchanges for months, with a focus on eliminating some forms of direct connectivity to exchanges.

Although there is a great deal of debate within the trading industry regarding the fairness and logic of some of the proposed restrictions, the question often asked by private traders and investors is, what do the current practices and proposed changes mean for me?

Downshift
In January, the Securities and Exchange Commission (SEC) proposed a new rule that would prohibit brokerages from providing certain customers the ability to trade directly on an exchange’s platform, a practice often referred to “unfiltered” or “naked” sponsored access (see “Sponsored access,” Active Trader, March 2010). Naked sponsored access essentially allows a proprietary high-speed trading firm to use its brokerage’s direct connection to an exchange to provide it with faster execution, rather than routing trades through the broker and then to the exchange.

The concern about this arrangement is the proprietary trading firm in this example is operating outside the risk-management controls of the brokerage, and also outside the audit trail of the SEC. A widely read Aite Group study of the practice estimated that 38 percent of all equity volume flows through naked sponsored access. (This figure is disputed by others in the industry, however, who estimate the percentage to be much lower.)

However, the potential impact of a ban on naked sponsored access appears fairly limited. Many of the larger high-frequency trading firms are broker-dealers that already have direct access to the markets. While this is good news for the high-speed industry itself, it’s bad news for those who want the measure to curb high-frequency trading overall.

“Most of the bigger high-frequency shops wouldn’t be impacted by this, anyway,” says Adam Sussman, director of research at TABB Group, who follows regulatory moves. “I don’t think it really curbs high-speed trading; it just puts some additional barriers to entry around who can actually perform and access the market.”

One suggested loophole for the naked sponsored-access firms would be to simply become broker-dealers, in which case they would have legal direct access to exchanges. But such a move involves additional fees, reporting responsibilities, and other management costs that may make it a less-than-palatable choice for some operations. Nonetheless, firms won’t stop looking for the technology edge.

“Yes, it levels the playing field somewhat if naked access is no longer attainable,” says Justin Schack, director of market structure analysis at Rosenblatt Securities. “Will the industry then look for another advantage? You can bet on it. In time, you’ll see attempts to restore some of that latency advantage, or open up a new one.”

For the complete article, see the April 2010 issue of Active Trader magazine. Click here to subscribe.



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