The SEC's proposed rules for sponsored market access or direct market access (DMA) have brought the challenges of the changing market structure landscape into focus. Speed of market access is an important aspect of algorithmic and high velocity trading. Brokerage firms have facilitated this need by allowing unregistered (not broker-dealers) direct access to the marketplace without the latency of time consuming risk and compliance monitoring.

Many firms do monitor activity after the fact, but for "fat finger" trades it is too late. The debate over sponsoring this unfettered access to the markets has raged inside investment banks for years. If your competitor grants access to large hedge funds or other institutions that rely on high velocity trading strategies, it becomes a competitive disadvantage if your firm does not allow it.

Compliance and risk departments are exposed when it comes to managing the risk of a billion dollar "fat finger" trade going through the system. The competitive disadvantage argument used by trading or prime brokerage units seems to fail when you consider that the sponsoring brokerage firm is on the hook for all naked access or DMA trades, whether intentional or erroneous.

There are similarities between the current naked access situation and the recent credit market dislocation in that firms were incentivized to take undue risks because their competitors were doing so and reaping significant revenue rewards. On Wall Street, if your competitor is making a 300 percent return and you are only making 100 percent, then you are pressured to take more risk to remain competitive. This is true of mortgage-backed securities and it is true of naked access. Hedge funds will take their business to firms that offer them the lowest latency and greatest flexibility, and firms that do not offer DMA will lose business. In today's environment, firms are less willing to lose these types of lucrative clients.

The SEC's efforts to impose some measure of risk controls on the risky DMA practice is a prudent way to level the playing field and enable firms to better control risk. If the SEC is successful, all firms will be required to do this pre-trade checking and those firms who currently offer naked access will not be rewarded at the expense of firms who will not grant their clients unfettered access to the markets.

There are low latency solutions to this problem. Technology platforms offer effective real-time risk controls with minimal latency. This kind of technology enables firms to conduct pre-trade risk analysis on the size of a single trade, aggregated market exposure and other basic checks on a real-time pre-trade basis.

Other more sophisticated checks such as market price manipulation, capacity and trade analysis can be done on a near real-time basis by taking drop copies of transactions as they flow to the marketplace and identifying potential issues within seconds of initiating a trade message. This type of risk control is prudent and will enable firms to better manage risk. By drafting new rules, the SEC will level the playing field and ensure all firms put the right tools in place to monitor all trade flow.

About the Author

Jim Heinzman is Managing Director responsible for securities markets products at Actimize, a leading financial crimes and compliance software provider to the financial services industry. He is a former Managing Director at Bear Stearns where he was responsible for supervision of the global equities division, including cash equities, derivatives, prime brokerage, asset management, and correspondent clearing.