By Dan Hubscher, Industry Marketing Manager - Capital Markets, Progress Software

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The practice of naked access, where a sponsoring broker enables a buy-side firm to trade direct on an exchange, marked the take-off of high frequency trading volumes. Sponsored access trading has quadrupled in the US over the past few years, comprising 38% (from 9% in 2005) of US volume, according to Aite Group. 

The US Securities and Exchange Commission proposed banning naked access in January 2010 and the comment period ended in March. It is likely to pass, despite opposition from some brokers. Now the Committee of European Securities Regulators (CESR) looks set to follow in the footsteps of the SEC and is investigating technology-driven issues including sponsored access. 

But trading firms are pushing back, saying that adding a risk management step - a "latency hop" - to the trading process would make them uncompetitive, and would cost the industry millions to implement. 

The Outcry Against "Latency Hops"

Prior to sponsored access, deals had to go to the broker (electronically or by voice), then through the broker's system to the exchange. Now, sponsored trades go straight into an exchange with no interference, risk checks, or "latency hops" imposed by the broker. Brokerage firms simply give their clients an exchange ID number, which the clients then enter into their algorithms so that they can trade directly with the exchange. 

Regulators are right to be concerned. Unfiltered access to trading destinations can end up causing trading errors or worse. For example, Credit Suisse was recently fined by an exchange after its algorithmic trading system went out of control and bombarded the exchange with hundreds of thousands of erroneous orders.

Under new rules in the US for broker-sponsored access to exchanges or ECNs, the SEC will require brokers or dealers to implement risk management controls and supervisory procedures. Pre-risk checks would help to prevent errors, trade limit breaches, or even fraudulent trading from occurring.

But pre-trade risk controls are considered disruptive by most market participants. After all, many of these hosted algorithmic trades are pure latency arbitrage, therefore the trading firm takes every available shortcut, even building their own hardware and writing the algorithms. A layer of risk management adds a third party into the mix, and - consequently - a delay.

This sounds like a valid criticism. After all if a 'latency hop' is introduced between entering a trade and its execution at a destination venue, then in theory this would slow down the trade process. But in practice, such a latency hop would be marginal - as little as milliseconds. And if everyone is required to add real-time, pre-trade risk management, then the competitive disadvantage is moot.

Introducing Risk Monitoring and Management

The benefits of being able to pro-actively monitor trades before they hit an exchange or ECN far outweigh any microscopic latency hops. They include catching "fat fingered" errors, preventing trading limits from being breached, and even warning brokers and regulators of potential fraud - all of which cost brokers, traders and regulators money.

The naked access playing field is hardly level in any event. There are trading systems out there that claim to throughput a trade in 16 microseconds from outside an exchange's firewall. Exchange and ECN systems range anywhere from 250 to 700 microseconds, according to measurements by latency management firm Corvil.

We are operating in a trading environment where trading firms actually measure the physical cable going from the trading server to the exchange matching engine. Latency is clearly an important issue. Complex event processing offers a solution.

Ultra low latency pre-trade risk management can be achieved by brokers without compromising speed of access.  An option is a low latency "risk firewall" utilizing complex event processing as its core, which can be benchmarked in the low microseconds.  With a real-time risk solution in place, a message can enter through an order management system, be run through the risk hurdles and checks, and leave for the exchange a few microseconds later.

It is the ideal solution to a tricky question - how do I manage risk before my trade hits the exchange without compromising speed? The benefits are clear - fat fingered trades, fraud, and breached trading limits cost brokers, traders and exchanges dearly. A latency hop of a few microseconds not only saves money, it can also prepare your firm for the regulatory future.