The risk of another "flash crash," which the SEC alleges was caused by a single large order, has put brokers on notice that they should not "toss any oversize or out-of-control orders into the market," according to Traders Magazine's Peter Chapman.   Adding to the tension is a recent report produced by a joint SEC/CFTC advisory committee that urges the SEC to work with FINRA and exchanges "to develop effective testing of sponsoring broker-dealer risk management controls and supervisory procedures."

All this concern has prompted 12 brokerages to collaborate on a set of risk guidelines intended for adoption across the industry.  Working under the aegis of FIX Protocol Limited, the group recently published a checklist of 13 risk controls it hopes will deter the acceptance of orders that might disrupt the marketplace.

Pressure from the money managers would eventually force all brokers to adopt the guidelines, which would reduce the likelihood of disruptive orders making their way into the markets.  Such an industry-based solution would, in turn, make the SEC happy, and perhaps forestall any new rules the regulator was considering.

That may be wishful thinking, because the SEC may wish for more - some say the guidelines lack teeth and are unlikely to dissuade the SEC from taking any action.

        Put Hard Numbers in Guidelines.   Some committee members reportedly wanted the brokers to incorporate hard numbers into the guidelines.  One possibility was automatically rejecting orders with a notional value of at least $500 million. Another was to reject any single order equal to 10% of the security's average daily volume.  This idea of hard numbers, however, didn't fly with others, who protested that it would reduce their flexibility.

"Unfortunately, there was almost universal push-back on that," one committee member said. "They said, 'We need the freedom to up those numbers when it makes sense.' Because of the push-back, this has become just a rough framework. I don't think the SEC will accept this."

Indeed, much of the discord among the FPL group centered around whether any orders should be automatically rejected. In the end, the committee agreed that orders that exceeded predetermined risk levels would be "paused" or routed to a sales trader who could exercise judgment. Rejecting an order outright was considered too punitive, some said, and could undermine all the hard work put into winning the client in the first place.

SEC Signals Introduction of New Rules.   The SEC has signaled it could introduce new rules to force brokers to take more responsibility to prevent such occurrences in the future.  And, it's already taken steps to eliminate so-called "naked sponsored access" arrangements, with Rule 15c3-5.  That rule was fine, but the joint SEC-CFTC advisory committee wants the SEC to go further.  It also applauded recent CFTC moves to consider specifying "as a disruptive trading practice the disorderly execution of particularly large orders."

And, the FPL guidelines have their limits.  Yes, they urge brokers to take into account a client's positions, but they do so only with regard to the security currently being traded - a stock.  The guidelines don't require brokers to aggregate a client's total positions across the firm.  The scope of the checklist is limited to the algorithmic or direct-market-access trading of cash equities.  It does not consider other asset classes or departments within a firm, such as program trading or derivatives.  As such, the guidelines may not go far enough for the SEC.

Nomura's Neal Goldstein notes that the SEC's objecives would be ideal, but difficult to achieve:  "To really quantify and manage counterparty risk, you need to have, at any moment, a snapshot of a client's total position" - which "would be a staggering undertaking."

For a copy of the original story, go to:   [Traders Magazine Online, 5/4/11, Peter Chapman]