SEC close to banning being naked while trading

By Jessica Holzer and Jacob Bunge
Of Dow Jones Newswires
10/22/10

WASHINGTON -(Dow Jones)- The Securities and Exchange Commission staff is close to finishing work on a rule that would ban "naked access," which allows some traders to do business anonymously, people familiar with the matter said.

Naked access, offered to customers by some major banks and brokerage firms, allows traders to buy and sell stocks on exchanges using a broker's computer code, which can shield their identity from regulators and exchanges.

The arrangement, used by some quantitative trading firms, lets them avoid being slowed by a broker's risk controls and helps to mask their trades from brokers running their own proprietary trading groups.

The move comes as U.S. securities regulators pursue a broad revamp of U.S. market structure, initiated following the financial crisis of 2008 and hastened by the "flash crash" of May 6.

In recent months the SEC and Commodity Futures Trading Commission have collaborated on a range of new trading rules aimed at controlling price swings in stocks, firming policies for voiding trades and tightening guidelines for market makers.

Banning naked access has been a priority of SEC Chairman Mary Schapiro, who has described the practice as "giving your car keys to a friend who doesn't have a license and letting him drive unaccompanied."

Chief among the concerns of regulators and lawmakers like Sen. Ted Kaufman ( D., Del.) is that a trading firm utilizing such access could ring up losses to such an extent that the broker providing the access could be destabilized. Brokers offering sponsored access typically are exposed to losses if the customer can't cover them.

Regulators also are wary that a trader doing business without proper risk checks in place could enter trades of such magnitude that the broader market could be affected. The SEC and CFTC early this month released a long-awaited report analyzing the flash crash that identified a major trade in stock index futures as a key component of the session's volatility.

The SEC staff is "very far along" in drafting a final rule banning the practice, one person familiar with the matter said, adding that the rule will be very similar to the SEC's original proposal on the issue.

The regulator in January proposed requiring brokers to subject clients to pretrade checks before giving access via their codes.

Traders would then need to direct market orders through the broker's computer systems before the orders go to the exchange, in an arrangement known as " sponsored access." By contrast, naked-access orders are largely subject to checks that occur after trades have been executed.

A final rule would have to be approved by a majority of the five-member commission.