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.