Sponsored access an even bigger issue?

Who would have ever thought that the debate about flash orders would get a public airing--replete with front page New York Times stories and outraged politicians issuing press releases.  

But there's a bigger issue out there that has so far only danced on the fringes of the flash order controversy. I doubt "sponsored access" will generate the same kind of public debate. (Lime Brokerage is certainly doing its part by referring to it as "naked access.") But one could argue that this is a more important issue with much farther reach. 

A document submitted to the SEC by Lime (posted by Zero Hedge) has gotten quite a bit of play on the Internet as of late. It's an eye-opener. Lime of course has garnered lots of attention as of later for its prowess and leadership in the high-frequency trading arena. It has weighed in on the sponsored access debate firmly against the practice. 

Recall that sponsored access allows a major client of a broker dealer to interact with market centers without going through a broker dealer. Rather it trades under the sponsorship of a broker dealer. The appeal is obvious. You get fast access to the markets and you essentially escape a lot of the regulatory overhang that broker dealers deal with. Lime's documents offer several examples, but the argument is simple. Sponsorees could easily get around NMS and SHO. And in lots of cases, who would know? 

Day traders could get around rules requiring to own shares to borrow, and frankly, because they end the day flat, the violation would not likely be detected. 

The danger here is that once sponsorees start trading on their own, they potentially acquire a fearsome power to wreak havoc in the markets. In this era of computer-driven, lightening fast trading, you need controls. Now broker dealers must be able to programmatically cancel faulty orders, and you essentially need prior review of orders to do that. 

If a sponsoree were to issue faulty-dare we say, fraudulent orders--there would be no recourse really. Exchanges couldn't act fast enough to cancel the orders. The sponsor would know only after the fact and the result could be really ugly. In this era, more than 100,000 orders could hit the market in just two minutes, wreaking havoc and even panic. 

Here's the line for which Lime is earning lots of attention: "The next Long-Term Capital meltdown will happen in a five-minute time period." Whew. My guess is that this sort of access will not be passed without a lot of pre-trade controls built in. Goldman Sachs has taken this view. - Jim