Wedbush's Bell On Sponsored Access: Put the Risk Controls Everywhere

With the practice of sponsored access - and naked access - coming under scrutiny from the SEC, there are several theories emerging as to what are the best ways to manage the risk and compliance of high frequency trading firms gaining direct access to market centers.Jeff Bell, SVP of Wedbush Morgan Securities, a leader in providing both sponsored access and direct market access (DMA) to broker-dealers and buy-side automated trading firms,recommends that the industry place the controls for monitoring risk at three points - broker, exchange and settlement level. In an interview with Advanced Trading, Bell - who has a background in technology and mainly in security- said one of the best defenses is an in-depth, layered approach to security.

"Instead of relying on a bouncer at the door of a bar to protect against minors getting in, the bar is better off making sure the waiters and other staff" are educated and can enforce the policy, said Bell. "In our world with financial services, the same concepts apply," said Bell. As a first level of defense, Bell said the broker has to understand the client's financial backgrounds and trading capabilities. Bell said brokers can allow the clients black-box system to be implemented but after that, "Don't just close your eyes. Look at their activity; is it in line with what you expect, and in line with regulations? And brokers can test it periodically," said Bell.

Under sponsored access, broker dealers let their clients use their market participant identifiers (MPIDs) to access market centers directly, without using the broker's trading system or network. Brokers are responsible for settling their clients' trades, so they need to make sure that the orders pass validation checks and are not exposing the client or broker to excessive risk.

Yet, there's speculation that some brokerage firms have turned off their pre-trade risk checks and compliance rules to appease their clients' demands for speed and are giving unfiltered access to exchanges and ECNs.

For this reason, exchanges also need to have good risk controls, according to Bell. However, some industry participants say that exchanges can only monitor order level checks, such as price, size and symbol, and are not able to see whether the automated trading firm has enough money in their account, or what their aggregate exposures are on other market centers.

Conceding that exchanges have some legitimate challenges - for instance, they can't know what the client is buying on one market and selling on another exchanges - Bell maintains they can help with odd lot trading, wash sales and other prohibitive and manipulative practices, he said. "Exchanges offer this today, and Wedbush is a big user of those solutions," said Bell. Also, there are new services that exchanges can introduce, such as identifying traffic that is anomalous. For instance, if an exchange knows a client's normal trading pattern, and it changes significantly, they can identity that and slow it down and provide controls for sponsored brokers to make those adjustments, Bell advises. "That's a technology solution that's applied at the exchange level. It's auditable and you have a high level of trust in it because it's done at a national exchange and you can implement it across the board on all clients and no one gets a one-up advantage."

The third leg is that the exchanges all implement in real time, trade data to the National Securities Clearing Corp. so that they can clear the trades. "If you are getting the feed in real time from all the various exchanges, the client is trading on Nasdaq, Arca and a dark pool, they are all identified with a common MPID and it comes into a risk system. If a client exceeds their buying power of $50 million, NSCC sends a message back to all the exchanges sending data. It immediately slows down their trading or stops it entirely and stops all open orders. That creates an open, auditable system from a trusted source, NSCC," said Bell.

"I think you have to put the risk management everywhere. You have to have good risk management at the clearing firms, and the exchanges and it has to be part of the overall part of the process," said Bell. In addition, Bell said it's unfair to view all sponsored access participants the same way. "You have a very different level of risk when you're dealing with a hedge fund or a small LLC that is not regulated," he said. The next level of risk is a broker-dealer, which is regulated, that is being sponsored into a venue, i.e., NYSE Arca, that it's not a member of, he said. The reason is the broker gets better economics or price breaks at the exchange if its order flow is aggregated through a clearing firm such as Wedbush. "We have a number of large firms that use Wedbush's services for sponsored access," even though the firms are members of Nasdaq, for instance, he notes. Because these firms are regulated as broker-dealers and are subject to regulations from the SEC and FINRA, he argues they pose less of a risk than hedge funds and other types of professional trading firm. Wedbush's Bells thinks the non-broker dealer client should have the strictest risk rules.

On the other hand, Bell contends that some of the high-frequency trading firms using sponsored access to reach execution venues have very capable technology and risk engines. "They should get credit for what they create," said Bell. I would argue that their risk management systems are far better than anything that a broker-dealer or exchanges could create for themselves," said Bell.With the practice of sponsored access - and naked access - coming under scrutiny from the SEC, there are several theories emerging as to what are the best ways to manage the risk and compliance of high frequency trading firms. Ivy is Editor-at-Large for Advanced Trading and Wall Street & Technology. Ivy is responsible for writing in-depth feature articles, daily blogs and news articles with a focus on automated trading in the capital markets. As an industry expert, Ivy has reported on a myriad ... View Full Bio