By Sang Lee
After years in obscurity, sponsored access emerged as a regulatory hot button issue in early 2009. More recently, it seems to have fallen off the regulatory radar screen, upstaged by high frequency trading, co-location and dark pools. Nevertheless, any future regulatory discussion regarding high frequency trading cannot take place without addressing the issues around sponsored access, and especially around the unfortunately named “naked” sponsored access.
One of our December 2009 reports titled ‘Land of Sponsored Access: Where the Naked Need Not Apply’, defines the sponsored access market, and provides estimates of sponsored access penetration of the U.S. equities market. This report also provides predictions on potential regulatory changes and possible impact on the overall evolution of the U.S. equities market. But, let’s start at the very beginning.
Sponsored access has many different meanings for market participants, and, while widely talked about, it is often misunderstood. The origin of sponsored access can be traced back to the practice of direct market access (DMA), in which a broker, who is a member of an exchange, provides its market participant identification (MPID) and exchange connectivity infrastructure to a customer interested in sending orders directly to the exchange. In this way, the broker has full control over the customer flow, including pre- and post-trade compliance and reporting. The DMA customer, in turn, gains direct access to major market centers. While firms opt to go through a sponsored access arrangement for many different reasons, reduction in latency is one of the main factors. Other, more basic reasons include additional revenue opportunities and hitting volume discounts.
There has been a lot of focus on the need for ongoing latency reduction to gain competitive edge. When breaking down the key sponsored access infrastructure components, network connectivity typically accounts for a significant portion, with an average of 450 microseconds. Exchange gateways add another 85 microseconds, and the industry average for typical pre-trade risk checks accounts for approximately 125 microseconds, with per-risk checks averaging anywhere from five to ten microseconds.
Latency levels across the three often-used types of market access (traditional DMA service; co-located, filtered sponsored access; and unfiltered sponsored access) vary widely, leading to a potential competitive edge for those firms able to achieve ultralow latency trading infrastructure. For traditional DMA services, the industry average currently ranges from four to eight milliseconds. For co-located, filtered sponsored access, the latency level dips into microseconds, ranging from 550 to 750 microseconds. Unfiltered sponsored access, not surprisingly, has the lowest range of latency, with 250 to 350 microseconds.
Challenges of Sponsored Access
Of course, sponsored access also has specific risks and challenges for participating parties as well as for the market overall. These include:
- Supporting non-filtered sponsored access can lead to sponsored participants taking unacceptable levels of risk, which can cause both great financial burden and reputational damage to the sponsoring broker.
- In order to support non-filtered sponsored access, sponsoring brokers must develop strong risk management and due diligence teams capable of handling the credit and operational risk of sponsored participants.
- Broker-to-broker sponsored access can lead to a situation in which the sponsoring broker loses track of the activities of the sponsored broker’s customer.
- Providing filtered sponsored access often leads to a higher pricing point for sponsored participants, leading to favorable competitive conditions for those brokers offering unfiltered sponsored access.
- While the potential is slim, there is a chance that a rogue sponsored participant can increase overall systemic risk.
Never Good to Be “Naked”?
Most of the current controversy in the marketplace regarding sponsored access has been focused on the unfiltered “naked”access model. The fear is that without real-time monitoring of sponsored participants’ overall trading activities, certain trading restrictions can be overlooked and potentially lead to a disaster. In the worst-case scenario, electronic fat fingering or intentional trading fraud that could take down not only the sponsored participant, but also the sponsoring broker and its counterparties, leading to an uncontrollable domino effect that would threaten overall systemic market stability.
It is certainly expected that the sponsoring brokers will conduct thorough due diligence of sponsored participants’ overall trading infrastructure. However, the opponents of unfiltered sponsored access fear that during live trading, without the sponsoring broker monitoring pre-trade risk checks in real-time, the chances for catastrophic trading error increase even with strict post-trade trading analysis. One danger of focusing on pret-rade risk filters in today’s high frequency trading market is that a significant percentage of false positives can occur when these filters are applied to specific trading strategies that produce many limit orders which are consequently cancelled. As a result, there has to be a certain level of distinction between the traditional pre-trade risk checks that are ideal for preventing “fat-finger” mistakes and “at the trade” risk checks (i.e., real-time immediate trade risk checks) that can provide risk coverage over high frequency trading activities.
Certain firms and unfiltered sponsored participants (e.g., brokers, hedge funds, and high frequency trading firms) contend that risk checks monitoring at the exchange-level, followed by post-trade drop copies, should be sufficient to analyze the overall trading risk being taken by the sponsored participants. The main arguments of this prounfiltered sponsored access segment include the following:
- Sponsored access helps level the playing field against larger brokers that are able to consistently hit volume discount.
- Detailed due diligence is conducted by sponsoring brokers to ensure that the sponsored participants do not cross specific risk thresholds.
- Sponsored participants typically operate their own sophisticated, pre-trade risk compliance platforms that adhere to the limitations set by the sponsoring brokers prior to going live.
On the other hand, firms like FTEN and Lime Brokerage, along with most of the bulge bracket firms, have highlighted the dangers behind unfiltered sponsored access, and emphasized the need for instituting a minimum level of sponsored, broker-monitored pre-trade risk checks within the sponsored participants. The main arguments of this antiunfiltered sponsored access segment include the following:
- Growing systemic risk due to usage of unfiltered sponsored access arrangements by unfit, less capitalized sponsored participants with questionable risk management capabilities.
- Use of unfiltered access provides unfair competitive advantages to firms that provide both clearing and market access services at a fraction of the cost of filtered sponsored access.
- Post-trade drop copies are not good enough risk management tools, and pre-trade risk checks should be a must-have to avert any inadvertent trading errors.
Despite the potential negative market impact caused by unfiltered sponsored access, there is considerable ambiguity from a regulatory perspective over whether or not “naked” access is currently legal. In order to have an efficient and profitable sponsored access service, the sponsoring brokers must have the following areas covered:
- Market center memberships;
- Relationships with third-party technology vendors or service bureaus with a low latency infrastructure that is stable and measurable (with an emphasis on consistency and reliability);
- Cost-efficient clearing arrangements;
- Cost-effective and operationally efficient collocation arrangements;
- Creation of an experienced due diligence team to analyze technology and the business stability of sponsored participants;
- Ability to hit market center volume tiers for volume discounts.
After much anticipation, the SEC finally released the long-awaited proposed rules on market access in late January 2010. While there are many details behind the proposed rules, in essence the SEC is looking to require sponsoring brokers to“establish, document, and maintain”direct and exclusive risk management and supervisory controls of sponsored entities. However, the proposed rules state that a certain level of flexibility would have to be built in to ensure that the controls and procedures fit the business models of broker-dealers and type of customer base.
While certain parts of the industry may resist some impending changes, most of the major market participants — including high frequency trading firms, sponsoring brokers and exchanges — agree that something should be done in terms of standardizing the overall sponsored access arrangements. The idea here is to level the playing field so that no single segment of the market has a clear advantage caused due to lack of industry uniformity in risk checks.
Still, it would be a mistake to think that increasing regulatory oversight on the activities of non-broker-dealers in sponsored access arrangements will eliminate all systemic risk from the institutional trading market. Recent history has shown that financial debacles caused by rogue traders or lack of risk controls can certainly occur within the regulated banks or brokerage operations. Indeed, some would strongly argue that most of the financial debacles of recent memory have occurred within heavily regulated broker-dealers, typically dealing with over-the-counter (OTC) instruments.
One danger here is that additional regulation in sponsored access may lead to a false sense of security. Uniformity and standardization in requisite pre- and post-trade risk checks should go a long way in paving the way for fair competition. That said additional regulation does not equal elimination of systemic risk. All major market participants must continue with their due diligence and scheduled audits to ensure that sponsored access arrangements remain a beneficial force in market structure evolution.
What do other experts say?
“Buy-sides continue to move beyond equities and into options, futures and fixed income. Trading these asset classes is converging, however risk management is not. In the equity space, Reg NMS has radically changed equity market making into an HFT model – creating greater intraday risk. Exchanges responded by creating pre-trade risk management controls for the brokers. The SEC is proposing to strengthen this by forcing brokers to take a pre-trade view of their risk across asset classes. The broker must estimate their risk based on their exposure to this client. It does not appear that the SEC is attempting to regulate the buy-side’s risk – only the broker’s risk if their buy-sides fail; so this isn’t part of the awkward multi-prime model. This regulation places a technical burden on each broker as they must create or purchase tools to monitor risk for each of their desks. A less burdensome approach may be to leverage a national institution to summarize this risk in real-time rather than charging each broker to implement these tools.”