Thursday, November 4, 2010

SEC Bans 'Naked Access'


WASHINGTON—The Securities and Exchange Commission voted on Wednesday to bar brokers from granting high-frequency traders unfiltered access to an exchange, a move aimed at imposing safeguards meant to prevent bad trades from disrupting the markets.

"Naked access" lets high-speed traders and others buy and sell stocks on exchanges using a broker's computer code without requiring them to filter through the broker's systems or undergo any pretrade checks.

Such trading arrangements have exploded with the growth of high-frequency trading firms, which rely on trading speed to make their money and don't want to be bogged down by a broker's controls. In some cases, brokers rely on assurances from traders that they have their own controls in place. Roughly 30% of market activity is currently conducted through naked access, said John Jacobs, director of operations at Lime Brokerage.

"We are concerned that order-entry errors in this setting can disrupt markets and, suddenly and significantly make a broker-dealer or other market participants financially vulnerable," SEC Chairman Mary Schapiro said.

The vote will have little impact on the largest high-frequency trading firms because they are broker-deals who have their own direct access to the markets. It will hurt smaller shops because they will either see their trading slowed down or they will need to shoulder the expenses that come with being a broker-dealer.

"It was very easy, until recently, for a very small shop to set up trading without adequate risk controls," said Jamil Nazarali, managing director at Knight Equity Markets.

Mutual funds and other investors that don't rely on trading speed to make their profits will be largely unaffected by the new rules, said Alison Crosthwait, director of global trading strategy at Instinet.

The five-member SEC voted unanimously to adopt a proposal it made in January requiring all brokers to put in place risk controls and supervisory procedures relating to how they and their customers access the market.

The rule effectively bans naked access because it requires brokers to funnel their customers' orders through these risk controls and conduct pretrade checks. Brokers will still be allowed to grant "sponsored" market access to their customers as long as the orders are filtered through the enhanced controls.

Unlike the proposal the SEC issued in January, the final rule would also apply to broker-dealer operators of alternative trading systems that offer market access to firms that aren't brokers. The change aims to fill a potential gap in the original proposal.

The new requirements come amid increased concern at the SEC that a large errant trade could spread havoc in the markets. Since the May 6 "flash crash," the agency has implemented mechanisms to prevent price swings in stocks. It is also undergoing an examination of stock-market rules.

The SEC estimates that maintaining the enhanced controls will cost the broker-dealer industry $100 million annually, an SEC official said. The cost will be spread unevenly among the 1,300 brokerages, some of which may have to put in place new systems.

Write to Jessica Holzer at and Kristina Peterson at

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