09:00 AM
Doug Engmann
Doug Engmann
Connect Directly

Raising the Bar on Co-Location for All Trading Firms

Any high-frequency trading firm that co-locates its servers at an exchange should have formal market-making responsibilities, be registered as a broker dealer, and be tracked for compliance with SEC rules.

There has been much discussion about the practice of co-location by exchanges as a crucial factor in high-speed trading in equities and options. Many commentators have said that the time, speed, and information advantage inherent in co-location has been in existence as long as exchanges have been trading. This had been true for many years and through different iterations of market structure, but these commentators fail to recognize the different conditions in which this practice took place.

Floor traders always had a time and place advantage in the equity or options markets. By being present on the floor where orders were being held and executed physically, they could act before that information left the floor. Even with the advent of electronic trading and the maintenance of electronic order books, access to the depth in the order book was restricted to certain persons registered as market makers or specialists.

However, the exchanges and the SEC imposed stringent requirements on those present on the floor. Floor traders, brokers, market makers, and specialists all had to be broker dealers; they were registered with the exchange and were subject to its regulatory scrutiny. Most importantly, market makers and specialists had affirmative obligations to make two-sided markets in the products they were trading. This provided liquidity to the customers of the exchange. Furthermore, floor brokers and traders/specialists/market makers had stringent rules about front running, trading ahead, and customer priority. All these issues draw complaints today about HFT practices by firms that are not broker dealers or subject to similar exchange oversight.

We could debate how effective these rules were in corralling unethical or illegal practices, such as trading ahead of your customer, or in ensuring a liquid market in times of volatility. But at least the principle was that traders with built-in advantages would have regulatory responsibilities that would be monitored by the exchanges.

However, with demutualization, the exchanges have substituted cash for regulatory responsibility as the tradeoff for firms wanting that time and place advantage. They gain that advantage by co-locating their servers on the new "floors" -- the server rooms of each exchange. The SEC recently fined the NYSE for allowing this practice without submitting a rule change to the commission, but it did not deal with the lack of regulatory responsibility associated with the practice of co-location.

Any trading firm at any exchange that wants co-location in an exchange's server room should have formal market-making responsibilities, be registered as a broker dealer, and be actively monitored for compliance with exchange and SEC rules. All others should be required to go through a broker. If that broker wants to co-locate its servers in the exchange's server room, it would be placed where it is at a slight millisecond disadvantage to the registered firms that are making markets.

The return of SEC registration and market-making responsibilities might not solve all the issues being raised by the market structure the SEC has created. However, it would be a big step in dealing with the time and place advantage that is now being sold to the highest bidder without any respect for the market responsibilities traditionally associated with that privilege.

Doug Engmann is President of Engmann Options Inc., a San Francisco private investment and securities consulting firm owned by the Engmann brothers, and Chairman of Sage Brokerage Holdings, LLC which is the parent of a broker-dealer servicing active professional traders. He ... View Full Bio
Comment  | 
Print  | 
More Insights
Oldest First  |  Newest First  |  Threaded View
User Rank: Author
5/31/2014 | 2:11:19 PM
Obligations for HFT?
Doug, you are suggsting that high frequency trading firms should have market-making obligations since they are benefiting from colocation, which gives them a time and place advantage today, without any obligations. 

You are suggesting that if HFTs don't register as broker dealers they should have a one milisecond disadvantage in the colo data center, whereas those who register as b-ds would have a speed advantage. Today, colocation supposedly gives everyone equal access. This would require shaking up the colocation rules so that speed of access is correlated with broker-registration.

I think today, those HFTs that are not registered as broker dealers have a  sponsored access agreement with a broker dealer or clearing firm. So they are gaining  privledges to access the market through that a clearing/credit risk relationship.

More Commentary
Leaving Out the Welcome Mat for Financial Services Hackers
Everyone knows the financial services industry is a prime target for hackers. Despite the dangers, many applications have software vulnerabilities that expose real risks.
4 Surprising Ways Firms Think About Data Security Costs
Almost 28% of firms are willing to bear the cost of some financial losses due to cybercrime, because it's less than the cost of upgrading IT systems.
CIO + CFO Doesn’t Equal Mars Vs. Venus
From my decades of experience, CIOs and CFOs have more in common than you may think.
Will Apple Legitimize Mobile Payments?
The company announced its new mobile payments system, Apple Pay, during a news media event today.
The Art and Science of Leveraging Cloud Infrastructure
Now that cloud providers have addressed many of the more practical concerns of their users, data segregation has become the major challenge in cloud deployments.
Register for Wall Street & Technology Newsletters
White Papers
Current Issue
Wall Street & Technology - July 2014
In addition to regular audits, the SEC will start to scrutinize the cyber-security preparedness of market participants.
Stressed Out by Compliance, Reputational Damage & Fines?
Stressed Out by Compliance, Reputational Damage & Fines?
Financial services executives are living in a "regulatory pressure cooker." Here's how executives are preparing for the new compliance requirements.