After years in obscurity, sponsored access has emerged as one of many regulatory hot buttons in early 2009. In recent months, however, sponsored access seems to have fallen off the regulatory radar screen, upstaged by high frequency trading, co-location and dark pools.
Whatever the case, any future regulatory discussion regarding high frequency trading cannot take place without addressing the issues around sponsored access, and especially around the unfortunately named “naked” sponsored access.
A new report from Aite Group entitled, Sponsored Access: Where the Naked Need Not Apply, defines the sponsored access market, and provides estimates of sponsored access penetration of the U.S. equities market. It includes predictions on potential regulatory changes and the possible impact on the overall evolution of the U.S. equities market.
Sponsored access has many different meanings for market participants, and, while widely talked about, is often misunderstood. The origin of sponsored access can be traced back to the practice of direct market access (DMA), in which a broker who is a member of an exchange provides its market participant identification (MPID) and exchange connectivity infrastructure to a customer interested in sending orders directly to the exchange.
To simplify things, Aite Group defines sponsored access as when a non-member entity (i.e., a sponsored participant) gains direct access to market centers by using the MPID of a member broker/dealer (i.e., sponsoring brokers), leveraging access infrastructure not owned by the sponsoring broker. Firms opt to go through a sponsored access arrangement for many different reasons. While reduction in latency is one of the factors, other, more basic reasons include additional revenue opportunities and hitting volume discounts.
Of course, most of the current controversy in the marketplace regarding sponsored access has been focused on the unfiltered naked access model. The fear is that without real-time monitoring of sponsored participants’ overall trading activities, certain trading restrictions can be overlooked and potentially lead to a disaster. In the worst-case scenario, electronic fat fingering or intentional trading fraud could take down not only the sponsored participant, but also the sponsoring broker and its counter parties, leading to an uncontrollable domino effect that would threaten overall systemic market stability.
Regulatory change dictating new practices related to sponsored access appears inevitable with unfiltered sponsored access coming under greater scrutiny. While certain parts of the industry may resist some impending changes, most of the major market participants — including high frequency trading firms, sponsoring brokers, and exchanges — agree that something should be done in terms of standardizing the overall sponsored access arrangements. The idea here is to level the playing field so that no one segment of the market has a clear advantage caused by lack of industry uniformity in risk checks.