November 9, 2010

Nobody Wants to See You Naked

Should we ban nakedness?

The SEC thinks so. Continuing a raft of rules in response to the Flash Crash, the commissioners voted last week to restrict “naked access,” or trading at somebody else’s terminal.

Executives and IR professionals, you’ll get questions. Your shares are affected by these rules. What do you know about naked access, and is stopping it good?

SEC Chairman Schapiro likened naked access to “giving your car keys to a friend who doesn’t have a license and letting him drive unaccompanied.” But the term is hyperbolic. “Sponsored Access” is better. Traders pay owners of market gateways like seats on exchanges for access. The renters do it for a speed advantage, anonymity, to save money, and to reach liquidity. These were also reasons the same parties once used a specialist on the floor.

The SEC is targeting access perceived to lack risk controls. The fear is that today’s complex algorithms – which the SEC has proposed now to certify – might unhinge the markets by entering from an unguarded spot. It’s a gambit, because there are no documented incidents of problems from these sources. The Flash Crash occurred within regulated walls. Mini flash crashes among individual stocks have happened through risk-managed channels. Experience would suggest then that you not breathe easier.

Where is this access and who’s using it? The kind targeted here would appear to us to be occurring mostly at small floor brokers. There are few left of what used to be called “two-dollar brokers.” After regulations desiccated floor commissions some few remaining floor brokers adapted to the Reg NMS world of fast, anonymous volumes by sponsoring access through their seats. Trading data indicate that the biggest users are institutions beta trading around holdings and large risk managers adjusting asset allocations.

It’s too bad that institutions trade around positions. That’s a symptom of a bad structure, not a cause, however. Now, these participants will be forced back to big broker-dealers. The SEC doesn’t hinder sponsored-access big guns like bulge brackets UBS and Goldman Sachs. Likewise, dominating high-speed sponsors such as the Wedbushes and Pensons have in-house risk systems or outsourced architecture from firms like FTEN. In essence, the SEC has picked winners and losers by rule.

We suspect that big banks, whose proprietary trading has been outlawed by Dodd-Frank, might have lobbied for this concession. Drive business back to us, they could reason, and you regulators can couch it as a response to risk. Along with proprietary trading firms, big banks are crucial to transactional and data revenues at the exchanges, which have invested heavily in both technology and a regulatory structure reliant on high-speed trading.

As to risk, we’ve increased it. Weren’t these big banks our bane two years back? Now we want them preventing financial calamity on the fruited plain, with help from the folks who never saw Bernie Madoff. Fills you with warm fuzzies. We’ve expanded rules, compliance requirements and costs, while concentrating compliant behavior through fewer channels and infusing it with a false sense of security by shifting oversight to brokers from customers. We can’t pronounce caveat emptor anymore.

And instead of diffusing risk through a diverse and free market, we’ve knotted it up in a kind of regulatory nylon twine that will keep things together long enough to make the next inevitable rupture that much more spectacular and disastrous.

And we haven’t touched the end of stub quotes and how an 8% guaranteed range is a lot easier for transient automated systems to game than prices set by participants free to trade as they please. No time today either, for the Continuous Audit Trail, the full scope of the Market Access Rule related to naked access, or the Large Trader Reporting System.

Are we daft? Were we to parent by prohibiting any behavior with consequence, our children would be psychopaths. The society they’d form would exist in a bubble waiting for the oxygen to run out.

If you think Orwellian notions belong only on pages of fiction, then by all means say so. It’s easy to write to Chairman Schapiro (we’ll tell you how) and express your reservations that a market run by five commissioners, big TARP recipients and some proprietary traders is the kind to guarantee vibrant future capital formation.

A last note: Veteran readers know we’ve long inveighed about monetary policy commoditizing equities. There is a big QE inflation quotient. You can’t grow an economy by 2% and a stock market by 100% and lay the spread on future earnings anticipation. It’s inflation. So it’s good to see the grand chorus now calling it crazy. Trouble is it’s Brazilians and Germans, not our government.

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