The practice of brokers giving high-frequency traders unfettered access to the U.S. stock markets is raising anxiety among industry players who fear the risks it poses and the damage that could be done to their own reputations.

Brokers, traders and exchanges have in the last few weeks grown increasingly frank about the possibility that a high-frequency trader's computer algorithm could go haywire, unleashing in the blink of an eye thousands of orders that could push firms over the edge and rattle the wider marketplace.

The U.S. Securities and Exchange Commission is probing the practice, known as sponsored naked access, where a brokerage with an exchange membership rents its identification badge to a nonmember trading firm, which is then able to shave valuable milliseconds from the time it takes to access markets.

You really have these guys going into the marketplace with loaded guns, Lou Matrone, sales trader at agency trading firm JonesTrading, which does not provide sponsored access, told an industry conference last week. Do we really know the risk?

Several of those at the Security Traders Association conference said they expect the SEC to in the next couple of months set rules that would bring some order to the patchwork of oversight used by brokers and the dozens of trading venues.

Many endorsed more robust pre-trade monitoring, as opposed to post-trade, which would likely frustrate the independent high-frequency trading firms, whose numbers have exploded in the last few years to dominate electronic market-making, as exchanges aggressively went electronic.

That delay could be a worthwhile trade-off if it saves the exchange-traded cash markets from a computer-sparked crisis that could paint its reputation with the same brush that has blackened the private over-the-counter markets, seen as the core of last year's financial crisis.

It's dangerous, it's going to be regulated, Washington is looking at that. We all know that. If there is a problem it taints everybody in this room, Andrew Silverman, managing director and co-head of electronic trading at Morgan Stanley (MS.N), told the conference held in Scottsdale, Arizona.

James Brigagliano, the SEC's co-acting director of trading and markets, said last month naked access is a front-burner concern for this fall to work to approve stated controls.

BEFORE OR AFTER?

So far, a proposal by Nasdaq Stock Market parent Nasdaq OMX (NDAQ.O) for new pre-trade rules has formed the basis for the naked access debate, attracting several letters to the SEC.

But there is a counterpush for post-trade oversight rules, from both high-frequency firms and those that provide naked access -- and who worry they could lose clients if oversight is bulked up before orders reach markets.

The Depository Trust & Clearing Corp, which runs the main clearinghouse for U.S. equities, told Reuters this month a handful of firms asked it to act as market-wide monitor of position limits for sponsored firms.

I don't think it's a bad backstop, but I don't think it solves the issue, Joseph Mecane, executive vice president of U.S. markets at Big Board parent NYSE Euronext (NYX.N), said of the DTCC-related plan in an interview last week.

There is a speed advantage to not having ... risk management procedures, so I can understand the demand for naked sponsored access, and for wanting to keep providing it, he said. But that just leads to more risk in the system.

To be sure, brokers, exchanges and high-frequency traders already have many-layered procedures place to monitor risk. The exchanges provide brokers real-time reports on clients' positions, while trading algorithms invariably have extensive risk checks.

Dan Weingarten, senior VP of U.S. sales and marketing at Pension Financial, which provides sponsored access, told the conference: It's our fine on the line, it's our reputation on the line, and we take that very seriously.

Still, open acknowledgment of a potentially major algo malfunction appears to be growing.

We've seen a number of instances where algorithms have gone wild, John Malitzis, VP of market surveillance at NYSE's oversight body, said last month. This is something that is happening not only in the U.S., but ... around the world.

High-frequency trading -- where banks, hedge funds, and independent shops use sophisticated software to profit from market imbalances -- is estimated to account for more than half of all U.S. equities trade.

The proportion of that done via naked access is unclear, with one speaker at the conference, Lime Brokerage Executive Vice President George Hessler, estimating it at well into ... a double digit percentage of the market.

New naked access rules represent the least onerous of possible changes that could limit high-frequency trading, which itself is being studied by the SEC.

Others are new rules to curb short selling and a new transaction tax, such as the one floated in Washington this month by the Economic Policy Institute, a left-leaning think tank.

(Editing by Steve Orlofsky)

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