Direct market access is a technological innovation that arrived on the scene as a way to speed up the execution of trades. Fueled by traders’ demands to adopt another cutting edge trading innovation, high-frequency trading (HFT), direct access shaves off inefficiencies from the traditional broker execution process. HFT and direct access have simultaneously become popular and infamous, and the debate rages on about their pros and cons. Some pundits call for an outright ban on HFT and direct access, claiming that the techniques are mindless speculative pursuits that cause market volatility and destroy legitimate profit of other, less technologically savvy, traders. Others argue that the technological innovations are designed to make markets even more efficient by enhancing transparency and adding liquidity. In this article, we examine the nature of direct access, its benefits and relationship with HFT, pro and con arguments for its existence, and related industry developments.
But first, a little detour into the history of trading innovations. In 1892, thousands of Americans petitioned the U.S. Congress to ban trading in futures. By eliminating trading in futures, the petitioners hoped to stop the “speculative gambling” that was creating volatility in the prices of commodities underlying the traded futures contracts, much akin to the sentiment displayed today by the opponents of HFT and direct access.
Why should we feel comfortable with futures today when a hundred years ago investors demanded their demise? Since the 19th century, a futures contract has remained largely the same: it is an obligation to transact a financial security at a designated time in the future. Back then, futures were a brand-new idea. Limited understanding of the technology fueled fears and further misinformation. In contrast, futures today are widely used to hedge risk, to lock in prices on inventory, and to reflect news in the underlying instruments. The information on how these products work has increased confidence in futures over the years, and few can imagine the modern trading world without futures contracts. The history of futures encourages the HFT and direct access practitioners to believe that information about the new trading techniques will help soothe fears of opponents of the new trading techniques.
Direct market access, as its name implies, is a way to connect to the execution venue with little, if any, “touch” from broker-dealers. Direct access is not a trading strategy, in the sense that direct access does not dictate which products to trade when, and at what price (the latter role being held by high-frequency trading). Instead, direct access is a computerized process to transmit trading and portfolio allocation decisions to an exchange or an alternative trading system. As with everything computerized, direct access enables faster, more accurate delivery of information, free of human errors, emotions, and misunderstandings.
Traditionally, broker-dealers offered their clients best execution services to route and execute trades in the least visible manner and at the best prices, in exchange for a fee. The advent of electronic trading and off-the-shelf algorithms has changed all that: not only do traders no longer need to pay brokers for services they can perform themselves, they also can save on execution time by avoiding brokers altogether. Direct access also addresses the situation where brokers compete with high-frequency traders by using their proprietary trading desks while providing market-making services.
A challenge with direct access is the potential for less rigorous pre-trade risk analytics. Broker-dealers perform a suite of risk management activities that would no longer take place if trades are routed directly to an exchange.
Specifically, the Futures Industry Association (FIA) Market Access Working Group, comprised of several prominent market players including CME Group, J.P. Morgan, Barclays Capital and Bank of America, has recently identified several sources of risk (see “Excedrin moments,” below).
Not all direct access was created equal. One type, dubbed “naked access,” is a completely unconstrained trading route to the markets that certainly poses considerable risks to other market participants. After all, how would any trader know whether their trading counterparty has funds to honor their trading orders if no one has conducted pre-trade compliance?
Another type of direct access, however, is free from these constraints and is rapidly emerging as a dominant way to do business: prudent direct access. “Going to market,” (below) illustrates various models of market access. In the traditional broker-dealer access model, a broker would determine the risk limits of a trader, based on the trader’s positions, cash in the account, and other related figures. The broker dealer would then pass the trader’s orders on to an exchange or an alternative trading venue, striving to deliver the best possible price. At the end of the day, all trading orders would be reconciled by a clearing house.
In the “naked access” model, the trader submits his orders directly to the exchange, bypassing most compliance activities traditionally performed by the broker-dealer. As with the traditional trading model, a clearing house reconciles the trades at the end of each trading day. This operating model leaves much to be desired: whether or not a particular trader is a credit-worthy counterparty is not verified until the trading day is over. As a result, with naked access, traders with limited funds who place numerous trades each day may truly wreak havoc in the markets by reneging on their trading obligations.
In the “prudent” direct access model, the clearinghouse assumes the real-time responsibilities of pre-trade risk checks. Companies like FTEN currently perform such functions, and their services are highly sought after by both traders and exchanges.
Finally, the FIA Market Access working group further suggested housing the clearing venues at exchanges, to ensure that no trader incurs a latency penalty following his decision to use a
Digressing for a moment, an insightful reader may ask: what is happening with the broker-dealers and why are they disappearing from the picture? The answer is two-fold:
- Traditional pre-trade checks were labor-intensive exercises in assessing the creditworthiness of a particular trader. Advances in technology have transformed pre-trade clearing into straightforward computer workflows that are easily accessible to clearinghouses.
- Many high-frequency traders increasingly find themselves in direct competition with brokers. Market-making strategies are designed to narrow broker-dealers’ spreads, and arbitrage strategies cut into the brokers’ proprietary trading teams. As a result, broker-dealers are playing a diminishing role in the execution process. Not surprisingly, this has led many broker dealers to publicly oppose high-frequency trading and direct access. Yet, however limited the role of broker-dealers may become in execution, broker-dealers will still remain on the front lines of providing leverage to their trading clients.
The working group also suggests the development of standardized risk management tools for exchanges. It has pointed out that a computer-communication language, akin to FIX (currently used by broker-dealers and their clients to exchange information), can transmit risk parameters and permissions among traders, clearinghouses and exchanges. A risk communication protocol, once developed, also will standardize risk controls among traders, exchanges and clearing houses. In turn, this will strengthen trading security, enable more transparency and better allow regulators to oversee the markets.
The working group recommended parameters for a risk communication protocol (see “Just in case,” below).
Additionally, the FIA working group has recommended that exchange and clearinghouse offer transparent guidelines on co-location and design and implement robust error trade policies ensuring that rightful transactions stand, and erroneous transactions are minimized.
The working group’s suggestions are timely and relevant to market participants trading futures. The proposed risk protocol if implemented thoughtfully may ease the volume of regulatory duties and exchange oversight. Once the risk metrics and the associated trade logs are enforced, regulators will be better able to monitor trading conditions and prevent future market crises. After an event similar to the “flash crash” of May 6, 2010, for example, the regulators would identify a “fat finger” error within minutes that could have caused the crash. With the advances in the technology for trading, exchanges need the transparency at the transaction level to prevent unintentional order entries from bringing down entire economies.
Perhaps the bigger question is the dual role played by firms that act as designated market makers and that also engage in HFT. What is beginning to emerge from the May 6 flash crash is that when the market begins to exhibit peculiar activity, HFT algorithms may shut down as an act of prudence. The problem is not what they are doing to the market when they are active but that they have come to be relied on to provide liquidity and if they let go of that rope, the rest of the market goes flying.
Irene Aldridge is a quantitative portfolio manager and managing partner at ABLE Alpha Trading, LTD., in New York City. She is also the author of “High-Frequency Trading: A Practical Guide to Algorithmic Strategies and Trading Systems.”