WASHINGTON/NEW YORK (Reuters) - U.S. securities regulators proposed rules on Wednesday that would require more supervision of unlicensed high-frequency traders who gain unfettered, or “naked,” access to public markets.
The Securities and Exchange Commission voted for a proposal that would require brokerages that rent out their access to the markets to have rules in place to protect against potential mishaps from unlicensed traders.
In the practice known as “sponsored” access, brokerages that have been approved to trade on an exchange rent their access to traders, who are then able to shave milliseconds from the time it takes to access the markets.
In “naked sponsored” access, also called “unfiltered” access, the brokers do not screen orders en route to markets, making electronic trading even faster.
“We are concerned that order entry errors in this setting could suddenly and significantly make a broker dealer or other market participants financially vulnerable within mere minutes or seconds,” said SEC Chairman Mary Schapiro.
The SEC said that the proposed rule would “effectively prohibit” brokerages from providing their clients with naked access to an exchange. The proposal is open for a 60-day comment period and would require another commission vote for adoption.
Naked access is now monitored by a patchwork of rules maintained by the exchanges, brokers, and trading firms. Some 38 percent of all U.S. stock trading is estimated to be done through naked access, a portion of it by high-frequency traders.
The proposal would require broker-dealers to implement risk controls and supervisory procedures to manage various risks, such as faulty orders.
Brokerages would have to, for example, implement controls to prevent the entry of orders that appear erroneous or exceed credit and capital thresholds.
“The more road blocks they put in front of these (trading firms), the more incentive there’s going to be for these guys to become broker-dealers” and monitor their own trading, said Larry Tabb, founder of research and consultancy TABB Group.
“If all you’re doing is licensing someone who shouldn’t have a license to drive recklessly, that’s not necessarily a good thing,” said Tabb, playing on a metaphor Schapiro used recently. “At least when you give your keys to the unlicensed driver, they’re driving with your license.”
The controls would have to be applied on a “pre-trade” basis, or before orders are routed to an exchange, under the SEC’s proposed rule.
Brokerages would not be allowed to outsource their supervisory procedures to third parties and would have to document and regularly review their risk management controls and procedures.
“It’s a bit of a surprise ... that the pre-trade checks will reside in the exclusive control of the broker,” said Jamie Selway, managing director at institutional broker White Cap Trading.
He noted that the SEC-sponsored access proposal “definitely goes further” than one by exchange operator Nasdaq OMX Group Inc, which served as the basis of industry debate last year.
Reporting by Rachelle Younglai and Jonathan Spicer, editing by Gerald E. McCormick and Derek Caney