WRAPUP 1-US SEC eyes efficiency in high-frequency probe

* Regulator plans paper on high-frequency trading in 2010

* Eyeing market efficiency, small- and mid-cap stocks

* Who should be responsible for new "naked" access rules

* Considering whether rules should apply pre or post-trade

By Jonathan Spicer

NEW YORK, Nov 4 (Reuters) - The U.S. Securities and Exchange Commission is focused on whether high-frequency trading makes markets more or less efficient, and on how new "sponsored naked access" rules should be applied and monitored, SEC officials said on Wednesday.

The regulator is delving deep into the structure of increasingly automated equity markets, which have been criticized both for favoring the most sophisticated players and for posing dangers in the event of a computer malfunction.

The SEC plans to issue a discussion paper early next year on high-frequency trading -- where banks, hedge funds and proprietary firms use lightning-fast computer algorithms to make markets and profit from tiny spreads and imbalances.

A major crackdown on high-frequency traders is seen as unlikely, given that investors now rely on the liquidity they provide. But any new rules could impact prices, spreads and the way buy and sell orders circulate through capital markets.

The SEC's discussion paper will likely include proposals to curb so-called naked access, where brokers allow trading firms to use their license, giving them unfettered access to markets. The firms, often high-frequency traders, are then able to shave valuable microseconds from the time it takes to trade stocks.

The SEC will focus on "who controls the controls," as well as whether the new risk controls should be applied before or after the trade is made, as it develops proposals, David Shillman, associate director of the regulator's trading and markets division, told a conference here.

He said the broker, their sponsored clients, or a third party could be tapped as rules monitor.

Some exchanges, banks, and investors have raised concerns that naked assess is dangerous if a computer algorithm at one trading firm malfunctions, causing chaos for others in the market. Brokers and exchanges now use a patchwork of oversight rules to monitor naked access.

Shillman said the SEC would likely build on a proposal by Nasdaq Stock Market parent Nasdaq OMX (NDAQ.O) for market-wide pre-trade standards. Nasdaq submitted its proposal nearly a year ago, and last undated it in October.

More broadly, the SEC is looking into the effect high-frequency trading has on long-term investors, including those trading small- and mid-cap stocks, Daniel Gray, senior special counsel in the SEC's division of market regulation, told the same FPL Americas conference.

"The most important thing that (the SEC) is focusing on ... is how are long-term investors doing," and whether markets are meeting the needs of both individuals and institutions such as pension and mutual funds, Gray said.