EXCLUSIVE – Fast traders push alternative US risk oversight plan

October 9, 2009

By Jonathan Spicer and Herbert Lash
NEW YORK, Oct 9 (Reuters) – A handful of companies, including high-frequency traders, have asked the U.S. stock clearinghouse to act as a market-wide monitor, to guard against the risk of a malfunctioning computer program spreading chaos.

The Depository Trust & Clearing Corp, which clears virtually all U.S. stock trading, said it has been approached in recent months to consider enforcing position limits on all market participants.

Both authorities and traders are concerned that a computer algorithm used to rapidly trade stocks could go haywire and spark chaos by building a massive position — setting off an adverse chain reaction in the blink of an eye.

The idea of involving DTCC has been presented as an alternative to proposals to crack down on direct market access, sometimes called DMA or “naked access.”

DMA is a controversial practice where high-frequency trading firms and others use a brokerage’s identification to submit orders directly to capital markets.

The monitor idea is still in a very early stage of thinking but is consistent with DTCC’s mission, Susan Cosgrove, the head of DTCC equities clearance and settlement, told Reuters.

“We’ve been hearing from a handful of firms. It certainly seems to be bubbling up,” Cosgrove said, adding that no plan has yet been defined or analyzed by the member-owned DTCC.

The plan would aggregate transactions from the more than 40 market centers, and make it instantly available to brokerages.

The DTCC, seen as a secure but bureaucratic entity, may have to convince regulators and the market it could effectively contain a major trading malfunction.

The U.S. Securities and Exchange Commission is looking into DMA and wants broad standards for the way brokers monitor the firms they sponsor. It has yet to formally propose rules.

Trading protections and position limits are already in place, but they vary among the brokers and between the venues.

Talks have so far centered on a proposal by Nasdaq OMX
to adopt pre-trade surveillance rules for brokerages, which could slow DMA firms’ path to the markets. The DTCC would serve as backstop protection after the trade is executed, under the new plan.

“There’s increasing pressure (for) real time review of the trade before it gets sent in,” said Robert Colby, former deputy director of the SEC’s trading and markets division, who is now Washington-based counsel at law firm Davis Polk & Wardwell.

“Some brokers don’t want to do it because it might slow the trade down and they’re afraid they’ll lose customers.”

Jeff Bell, executive vice president at broker-dealer Wedbush Securities, which clears trades for big high-frequency firms, this summer proposed the idea to install DTCC as monitor of the highly fragmented stock markets.

“One of the key elements to our thinking is that the risk controls should be placed throughout the whole ecosystem,” said Bell, who heads clearing and technology at Wedbush, a DMA provider and Nasdaq’s top liquidity provider since 2006.

“There is some concern about new entrants (trading firms) and the pressures that creates from a risk management standpoint,” added Bell, who also sits on a DTCC operations committee, but does not speak for the clearinghouse.

A main thrust of the Obama administration’s regulatory reform plan is to make markets more secure.

Under Bell’s plan, which is backed by some high-frequency firms, market centers would give the DTCC real-time drop copy reports of all order messages placed by traders. The clearer would alert brokers when DMA firms exceed their position limits, a job now shared by brokers and exchanges. The brokers could then move to shut the traders down.

Cosgrove said it was too early to estimate costs or a timeline. But the move would be a major undertaking, and several industry sources called the plan a long-shot.

The DTCC would need a big technology upgrade and approval from the majority of its users, in addition to convincing regulators it is up to the task.

Lime Brokerage warned in a June letter to the SEC about monitoring trades after they are executed. The firm said a lag in time between the execution and the recognition of a bad order could cause serious damage.

It cited an erroneous $31 billion order by UBS AG in February that was more than 100,000 times the intended amount, and a 2004 error that resulted in a $10.8 billion order at Morgan Stanley, instead of a $10.8 million order.

“If these large institutions have their electronic systems go awry, what about a small hedge fund?” said John Jacobs, chief operations officer at Lime, which caters to hedge funds and broker-dealers.

Still, the plan could appeal to the growing ranks of high-frequency traders, the market’s fastest players who use algorithms to profit from thin price spreads, and who now account for more than half of all U.S. equity volumes.

“What’s not in place is an industry utility like the DTCC that takes all of these drop copies in real time and … provides yet another level of risk check,” said Richard Gorelick, CEO of high-frequency proprietary trader RGM Advisors, who generally favors the proposal.

Matt Schrecengost, chief operating officer at Chicago-based Jump Trading, said he fully backs efforts for trading firms to adopt drop copy reconciliation reports, and for exchanges to take a more central role in safety and operational risk.

A centralized exchange-based approach would be more effective than relying on each firm to create their own mechanisms, Schrecengost said in an e-mail.

Jump, a high-frequency trading firm, said it will push for adoption of such a plan at an annual Futures Industry Association conference in Chicago later this month.

(Reporting by Jonathan Spicer and Herbert Lash; Editing by Tim Dobbyn) ((jonathan.spicer@thomsonreuters.com; +1-646-223-6253; Reuters Messaging: jonathan.spicer.reuters.com@reuters.net))

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