Following a series of mishaps—which include the ‘flash crash’, the Facebook IPO and Knight Capital—electronic trading platforms and operations are receiving close scrutiny from regulators and market participants alike.

The Securities and Exchange Commission’s market access rule, or 15c3-5, applies to broker-dealers with market access to an exchange or alternative trading system, as well as to broker-dealers that provide customers or other persons with access to trading securities directly on an exchange or alternative trading system.

Under the rule, the broker-dealer is responsible for having risk management controls and supervisory procedures reasonably designed to ensure compliance with all laws, rules and regulations.

“The market access rule went into effect a year ago and had a great impact on trading technology, with a significant amount of work done last year so that all broker-dealers with access to exchanges were able to, among other things, implement controls to prevent errors such as fat finger order entries that could disrupt the market,” said Jess Haberman, director of compliance at Fidessa, a trading technology firm.

“There is still work to be done as broker-dealers gain experience with the new functionality and fine tune it.”

Erroneous Orders
The SEC’s market access rule “has been widely cited in discussions of the Knight Capital disaster of August 1, when erroneous orders from the market maker inundated the New York Stock Exchange for 40 minutes”, said David Zinberg, principal, financial services and insurance, capital markets at Infosys, a software provider. “The rule requires broker-dealers to implement risk controls that would block erroneous orders from reaching exchanges and other market centers.”

A traditional way that buy-side firms have addressed many of their regulatory compliance requirements has been to transfer the practical responsibility for compliance to their service providers, and particularly to the sell-side firms with whom they deal.

That’s no longer feasible.

“The need for the buy-side’s brokers to comply in turn requires the buy-side institution to provide the necessary information to satisfy the broker’s pre-order compliance checks,” said Alberto Corvo, managing principal for financial services at eClerx, an outsourcing firm.

Exchange members have too often assumed, without checking first, that their buy-side clients have appropriate risk management systems in place to control their direct market access (DMA) activities.

”Direct market access to exchanges gave buy-side firms rights without responsibilities,” said Chris Pickles, head of industry initiatives at BT Global Banking & Financial Markets, a communications provider.

Exchanges have assumed that their members have the appropriate risk management systems in place to monitor their clients’ DMA activities.

“Everyone has assumed that someone else is responsible for risk management and that they could walk away from their own responsibilities,” Pickles said. “More regulations internationally are now making it clear that the buy side has legal responsibility for its own compliance and cannot pass that off to another party.”

In Europe, MiFID II will require that an investment firm that provides direct electronic access to a trading venue shall have in place effective systems and controls, and that persons using the service are prevented from exceeding appropriate pre-set trading and credit thresholds, that trading by persons using the service is properly monitored, and that appropriate risk controls prevent trading that may create risks to the investment firm itself or that could create or contribute to a disorderly market.

Balancing Act
For a hedge fund, compliance with the SEC’s market access rule involves a delicate balancing act whereby pre-trade risk checks need to be exhaustive without compromising speed.

“The market access rule is fundamentally about monitoring the risk of flow over sponsored access and DMA,” said Theo Hildyard, capital markets product manager at Progress Software, a software provider.

The overriding principle “is that prevention is better than cure, and if orders will create or contribute to a disorderly market, break margin/position limits or break some regulatory requirement if executed then steps should be taken to prevent them hitting the market in the first place”, Hildyard said.

One solution lies in speeding up the process by which data is stored and retrieved, which in the case of a large-scale trading shop can involve trillions of records. “This introduces a new technology layer that must sit between order origination and the execution,” said Hildyard.

Hardware in the form of appliances called FPGA (field-programmable gate array) are designed to enforce pre-market risks in nanoseconds, while preventing impact on latencies that historically have slowed down traditional trading systems and models.

Specialized microchips employing FPGA have near-zero impact on latency for governing required checks directed by Rule 15c3-5 and similar regulations from other regulatory governing bodies.

If data can be stored and processed in one location, business latency is reduced, which gives firms an edge when reacting to market data.

Trading platforms are embedding specialized hardware capable of addressing industry pain points such as pre-trade risk, compliance and ultra-low latency execution.

This raises two questions, according to Hildyard. “What are the business rules in place in this layer and to what extent are they open to interpretation?” he said. “In a world dominated by the latency arms race, can these controls ever truly be effective when the tendency will be to make them as quick—and therefore simple—as possible?”