Sunday, November 29, 2009

An Answer for the 'Naked' Sponsored Access Controversy

With my current work in technologies within the financial market, I see low-latent risk management software applications as an answer for the controversy surrounding 'naked' sponsored access. But before I delve into the details of how such a solution would work, let me set the context of this posting with some background.

For those of you unfamiliar with some of the intricacies of the financial market, here’s a quick summary of what you see in the picture to the left regarding sponsored access. Brokers, like Bank of America and Goldman Sachs, are members of exchanges (ie. NYSE, Nasdaq, etc.). Brokers go through registrations, pay considerable fees, and are regulated to have access to these markets. Clients of these brokers who are interested in high-volume trading, for example in some cases hedge funds, want access to these markets.

Traditionally clients would pay the brokers a fee to access the markets via the broker’s own internal systems. It’s a win for the broker, who generates extra income in charging for access, and a win for the exchange which makes its money with the increase in trading volume.

The problem arises as more and more clients, who are also interested in high-frequency trading, want faster access to the markets. Using the broker’s internal systems to access these markets only increases the latency. The clients already have their own networks, usually optimized to meet their performance objectives, whereas the brokers may or may not. Either way, the broker’s systems will only add to the latency by adding an additional 'hop' to reach the market. (Again for those of you unfamiliar with high-frequency trading and the sensitivity surrounding latency, performance is measured in milliseconds and microseconds.)

To address latency concerns among their clients, brokers have given them 'naked' access to these markets (NYSE, Nasdaq, etc.) by providing their broker 'market-participant IDs.' The client (ie. hedge fund) directly accesses the market as if they were the broker (Bank of America, Goldman Sachs, etc.). The advantage is that the client bypasses the broker’s internal systems, directly connecting to the actual exchange, and avoids the additional latency.

Two problems, among others, that arise from naked sponsored access are:
  • Since clients are using the market-participant ID of the broker, the market is unaware that the trader is not the actual broker but a client of that broker. This therefore puts to question transparency (one major purpose of exchanges).
  • The broker is also held responsible for all trades made on behalf of those clients, since it’s their market-participant ID being used on that exchange. This puts brokers at risk of a client over-leveraging. Multiply the risk of over-leveraging by the number of clients trading with naked sponsored access, and there are legitimate concerns of another financial crisis.

This past November 20th, Senator Ted Kaufman urged the Securities and Exchange Commission (SEC) to stop sponsored access all together. The issue argued by many against the senator’s move is that sponsored access accounts for more than 50% of the daily trading volume that occurs on exchanges today. Sponsored access has also created more liquidity for buyers and sellers, essential for trading.

A variety of firms have explored and invested in building a low-latent solution to address the concerns surrounding naked sponsored access. The solution they’ve built is a low-latent risk management application which sits on top of naked sponsored access. A division at NYSE Euronext, NYSE Technologies, calls their solution a Risk Management Gateway (RMG).

What does it provide? Sponsoring brokers can manage the risk of their clients through a web-based user interface that allow them to:

  • Manage a set of trade filters, that are configurable, and controls the level of risk for each of the sponsoring broker’s clients. Once a threshold is hit, the RMG can block further trading activity until a risk manager/administrator removes the block or resets the limits.
  • A means to visually monitor the level of risk based on all client order activity pre and post trade.
  • Cancel all orders, or specific orders, for a given client.

RMG, and other low-latent risk management products like it, may be a way forward to keeping the practice of naked sponsored access alive with secure enough safeguards to prevent abuse by high-frequency traders.

Technology is moving so fast that it’s hard for the SEC to keep up with deciding what the right amount of regulation is needed while understanding all the ramifications with or without it.

Click here to read more about the Wall Street Journal's article on 'naked' sponsored access.

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