Broker-dealers are taking very different approaches to a new rule that requires them to scrutinize customers' credit positions and block reckless orders before trades are executed, setting off finger-pointing and new challenges for regulators.
Some firms are accusing rivals of casually interpreting a Securities and Exchange Commission rule that bans giving clients "naked" access to the marketplace, according to interviews with more than a dozen Wall Street officials and regulators.
At issue is the SEC's market access rule, which takes full effect in late November. It is aimed at ending a practice in which brokers give high-frequency trading firms (HFTs), hedge funds and some of their other most active customers a direct pipeline to exchanges without any pre-trade supervision.
Such access has been blamed for "fat finger" and "algo" problems in which errant keystrokes or a cascade of trades can destabilize markets within seconds.
Broker-dealers ranging in size from Morgan Stanley to clearing firm Penson Worldwide have scrambled to build, buy or outsource the needed surveillance systems with hopes of retaining existing clients or attracting new ones.
They are caught between clients that loathe any delays in sending their bids and offers and regulators demanding "reasonable" and "defensible" pre-trade oversight. The question is how far brokers will push the limits of the rule.
"We may end up having regulation by enforcement, and I think that's dangerous," said George Hessler, CEO of broker-dealer Stock USA, which hired an outside firm for its surveillance. "We made our own interpretations and went ahead with the implementation."
The issue often arises when principle-based regulation is offered instead of specific rule guidance. "The differences between the interpretations are broad, not tight," said an electronic trading executive at one large bank, speaking on condition of anonymity.
Another sniped that some of his competitors are "selectively choosing not to adhere" to the intention of the rule.
The SEC adopted the market access rule in November in one of Chairman Mary Schapiro's first attempts to rein in the risks of high-frequency trading following the May 2010 "flash crash.
The rule hits directly at brokers, themselves among the most sophisticated HFTs, who have sole responsibility for screening all orders before they are sent to exchanges. Traders who make their profits by deluging marketplaces with a flood of orders to take advantage of minuscule pricing differences, loathe any delays, even a few more microseconds.
The new rule is taking effect in phases. Since July 14, brokers have had to check for erroneous or manipulative orders on stocks, bonds and options, something that had usually occurred after a trade was executed. The tricky next phase begins on November 30 and requires brokers to check that orders do not exceed credit or capital limits they have set up for clients.
The limit check is especially problematic with large clients that trade in many asset classes and through several brokers. The limit check and a requirement that brokers have "direct and exclusive control" over whether to block the orders have caused the most friction, according to industry executives and regulators.
The Financial Industry Regulatory Authority (FINRA), which enforces the market access rule, has identified 20 to 25 brokers it plans to examine for compliance, said Tom Gira, executive vice president of FINRA's market regulation unit.
FINRA wants "to make sure that firms have made a good-faith attempt to comply with the rule", he said at an industry conference on September 21. "I'm sure there will be firms that we might be troubled by what we see," he said.
FINRA has already begun its blitz of firms, according to two brokerage officials. One said the regulator wants to ensure that large brokers are building internal surveillance systems and not simply outsourcing it to one of the many technology providers vying for new business.
A regulator from another agency, who asked not to be named, told Reuters he would not be surprised if some brokerages "pushed the envelope" and allowed clients to have some access to the controls.
At the conference, Gira said the standards to be enforced will likely evolve over time.
Though several brokers said the number of erroneous trades has fallen since the rule began rolling out in July, there are still incidents. One such trade, which halted trading in Exxon Mobil, was canceled on August 11.
The stakes are high for an industry that must bulk up what was a patchwork of screening for bad orders. Brokers will spend some $220 million this year to abide by the rule, up 18 percent from last year, and costs should rise through 2014, estimated Miranda Mizen, a principal at consultancy TABB Group.
Meanwhile, there are already signs that the rule has hit some of the biggest providers of what is known as "sponsored access."
Wedbush Securities was for years the Nasdaq Stock Market's top liquidity provider, thanks to clients that funneled orders through its pipes to get low trading fees and fast access to exchanges. But in August it had dropped to third in Nasdaq-listed stocks and to sixth in NYSE-listed stocks, suggesting some broker-dealer clients cut out the middle man.
While many Wall Street firms adapted or built internal systems, Wedbush responded to the SEC's rule by acquiring Lime Brokerage, a specialist in pre-trade surveillance. Jeff Bell, Wedbush's head of clearing and technology, said it is also offering clients alternative software-based products.
Penson, another big sponsored access provider, decided not to build or buy. Instead, it is using several outside surveillance providers for customers, said Bill Yancey, CEO of the firm's Penson Financial Services unit.
"Some customers ... might want to become broker-dealers themselves, and some execution-only customers might want to procure both execution and clearing services from the same place," Yancey said. "It's going to be a sea change. We're moving from a post-trade world to a pre-trade world."
Large brokers hoping to take advantage of the new world are complaining that some rivals are cutting corners in an effort to attract or retain HFT clients. Much of their focus involves the credit limits for individual clients.
The SEC, aiming to protect brokers and clients from a financial blow-up, did not specify whether the limits should be based on buying power, net capital or some other measure. It did not publish FAQs as it sometimes does for new rules.
It did, however, publish eight suggestions last week on how brokers can screen so-called sub-accounts for money laundering, insider trading and market manipulation by their clients.
Yet many questions remain, and regulators are not expected to give specifics for at least another year.
"Different market actors will necessarily interpret the rule differently based on their role in the marketplace," said Joanna Fields, head of equity market structure for the Americas at Deutsche Bank. She said the bank has developed its own risk-check technology.
Technology vendors, such as Nasdaq OMX Group's FTEN, have been pitching software- and hardware-based surveillance systems that they say take no more than 10 microseconds -- one-millionth of a second -- to do the job.
Louis Liu, founder of New York-based vendor Matrix Trading Technologies, said the pressure is intense to provide robust order screening in as little time as possible.
"You're being pushed by the regulators on one side, and by the customer on the other side," he said. "Eventually you just push into the wall of physics."