Insight: Brokers point fingers over "naked access" rule
Oct 2, 2011, 10:29 a.m.
By Jonathan Spicer
NEW YORK (Reuters) - Broker-dealers are taking very different approaches to a new rule that requires them to scrutinize customers' credit positions and block reckless orders before trades are executed, setting off finger-pointing and new challenges for regulators.
Some firms are accusing rivals of casually interpreting a Securities and Exchange Commission rule that bans giving clients "naked" access to the marketplace, according to interviews with more than a dozen Wall Street officials and regulators.
At issue is the SEC's market access rule, which takes full effect in late November. It is aimed at ending a practice in which brokers give high-frequency trading firms (HFTs), hedge funds and some of their other most active customers a direct pipeline to exchanges without any pre-trade supervision.
Such access has been blamed for "fat finger" and "algo" problems in which errant keystrokes or a cascade of trades can destabilize markets within seconds.
Broker-dealers ranging in size from Morgan Stanley to clearing firm Penson Worldwide have scrambled to build, buy or outsource the needed surveillance systems with hopes of retaining existing clients or attracting new ones.
They are caught between clients that loathe any delays in sending their bids and offers and regulators demanding "reasonable" and "defensible" pre-trade oversight. The question is how far brokers will push the limits of the rule.
"We may end up having regulation by enforcement, and I think that's dangerous," said George Hessler, CEO of broker-dealer Stock USA, which hired an outside firm for its surveillance. "We made our own interpretations and went ahead with the implementation."
The issue often arises when principle-based regulation is offered instead of specific rule guidance. "The differences between the interpretations are broad, not tight," said an electronic trading executive at one large bank, speaking on condition of anonymity.
Another sniped that some of his competitors are "selectively choosing not to adhere" to the intention of the rule.
The SEC adopted the market access rule in November in one of Chairman Mary Schapiro's first attempts to rein in the risks of high-frequency trading following the May 2010 "flash crash.
The rule hits directly at brokers, themselves among the most sophisticated HFTs, who have sole responsibility for screening all orders before they are sent to exchanges. Traders who make their profits by deluging marketplaces with a flood of orders to take advantage of minuscule pricing differences, loathe any delays, even a few more microseconds.
The new rule is taking effect in phases. Since July 14, brokers have had to check for erroneous or manipulative orders on stocks, bonds and options, something that had usually occurred after a trade was executed. The tricky next phase begins on November 30 and requires brokers to check that orders do not exceed credit or capital limits they have set up for clients.
The limit check is especially problematic with large clients that trade in many asset classes and through several brokers. The limit check and a requirement that brokers have "direct and exclusive control" over whether to block the orders have caused the most friction, according to industry executives and regulators.