The biggest stock market operator in the country, TMX Group Inc., has lots of problems with a proposed new competitor. Among them, TMX is telling regulators, is that the planned Aequitas exchange's solution to a perceived problem with high-frequency traders (HFT) likely won't work.
The Aequitas group, backed by Royal Bank of Canada among others, is proposing to build a market that would try to deliberately exclude high-frequency traders from some types of trading in a bid to attract business from investors frustrated with what they see as markets twisted all out of shape by HFT activity.
The plan raises all sorts of thorny issues about fairness and access that regulators at the Ontario Securities Commission have flagged. Because of that, the OSC asked for feedback, and it's pouring in.
The TMX submission lays out lots of concerns, including an underlying argument that key principles governing how markets work shouldn't be altered on a piecemeal basis to address commercial proposals. (The counterargument is that is the way a lot of innovation works. Somebody invents cars, then we build wider roads and write rules on driving, rather than saying you can't invent cars until we decide to change the rules so that cars would be allowed.)
TMX argues that there is no settled, evidence-based consensus that high-frequency trading is behind the erosion of confidence in the markets. The argument is indeed still raging (and there's a new study from the C.D. Howe Institute that came out Thursday that adds to the debate.)
One of TMX's most interesting points is that there are plenty of reasons to argue that the system that Aequitas proposes simply won't work.
The plan Aequitas proposes is to create a special environment that is free from some of what it calls the most predatory high-frequency trading strategies. The planned new exchange proposes to do that by barring traders who are tagged with a specific regulatory marker from making certain kinds of trades.
"Aequitas has premised its proposal on issues for which there is no consensus, and propose [sic] a solution that will not resolve the issues," TMX equity markets head Kevan Cowan said in his submission to the Ontario Securities Commission.
For example, he points out that many so-called bad HFT strategies are based on posting quotes, rather than using market orders to trade on orders that other investors have posted. HFTs will still be able to post quotes in the Aequitas system, and will be barred from using market orders in some instances. In other words, Aequitas is stopping the wrong kinds of trades to do what it wants to do.
"Many of the 'predatory' HFT strategies, including 'disappearing quotes', 'passive front running' and 'quote pennying' are based on posting and cancelling posted liquidity at precise moments in time, and will therefore not be excluded from the Hybrid market."
Mr. Cowan also argues that the Aequitas plan to identify likely HFTs using a regulatory tag is flawed. The idea is to use the short-market exempt marker, or SME tag.
SME markers apply to market users who finish the day flat, rather than holding investments longer. The Aequitas backers use that as a proxy for HFTs. It's a bit of a blunt instrument, but it should capture HFTs, Aequitas argues. On one Aequitas market, for example, SME tagged traders would not be able to use market orders.
Mr. Cowan argues that "practice shows that not all HFTs are SMEs and not all SMEs are HFTs. In addition, HFTs are broadening their trading strategies, making the SME marker an even farther departure from a proxy for HFT activity." He adds that "using the SME marker excludes a whole class of traders that do not engage in the type of activity Aequitas is looking to restrict. Such SME participants, including market makers, provide the service of bridging buyers and sellers in time, or across markets, which positively contributes to liquidity. These SME participants should not have their access restricted."
Given all that , Mr. Cowan argues that the industry shouldn't have to go through rule changes and added costs for something that may not work.
(Boyd Erman is a Globe and Mail Reporter & Streetwise Columnist.)
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