See related feature: Naked Access Attracts High-Frequency Traders, Gets Regulators’ Attention
Not every buy-side firm conducting high-frequency trading is choosing the sponsored-access route. "We are absolutely not doing sponsored access or naked access," explains Eric Pritchett, CEO of PhaseCapital, a private investment adviser in Boston that currently is advising one systematic high-frequency hedge fund. Instead, he says, the firm has chosen a direct market access (DMA) arrangement. "Naked access" refers to a buy-side firm connecting its black box or algorithmic logic directly to the matching engine of a market center without any risk monitoring by the sponsoring broker.
According to Pritchett, PhaseCapital executes through Lime Brokerage's pipes, while relying on Goldman Sachs as its prime broker for risk monitoring. "DMA means that we trade directly against the exchanges using Lime as our executing broker," explains Pritchett. "This means we are in control of our trading and our technology, and we use Lime for their pipes, data feeds and to carry messaging to and from the various markets."
Lime provides DMA access to multiple market centers from its data center in Jersey City, N. J. PhaseCapital taps Lime to gain access to colocation services and to market and trade data, Pritchett adds.
"We're definitely a high-frequency trading shop. But increasingly this means different things to different audiences," says Pritchett. "We don't trade tick arbitrage or other strategies that are so sensitive to latency that they require being directly integrated to the liquidity venue with nothing between us and the quote book." Instead of colocating with each market center, "Lime gives us aggregated access with sub-millisecond performance," he notes.
"I'm not aware of any monitoring that Lime does other than regulatory monitoring for short selling or technical system performance on their side," relates Pritchett. "If I want to short stock and I don't have a locate [to deliver the stock] at Goldman, Lime will block the trade."
Though Pritchett points out that Lime's systems are not limited to checking short locates from Goldman, he believes it's the prime broker that should be monitoring margin balances and overall risks. "The Goldman risk desk monitors our portfolio, and the prime broker is responsible for monitoring leverage relationships that they extend to clients," says Pritchett.
In the case of DMA trading, the prime broker typically views the client's trading activity at the end of the day, often the starting point for monitoring. "But if they started to see abuses they could request to see client trading activity more frequently," Pritchett says, emphasizing the importance of the prime broker and the buy-side client sharing a unified view of the risks presented by the client to the bank.
"There probably are reasons I'm unaware of for people [to] want to have sponsored access or naked access," Pritchett continues. "The motivations for having that kind of setup could reflect trying to squeeze out every millisecond of latency for transactions in the marketplace."
Whether or not that introduces risk, according to Pritchett, is a question that has to be answered by the prime broker that stands behind the settlement of a trade and investors who are putting capital at risk in the strategy.