Stock trades take tiny fractions of seconds, while stock trading regulations too often take years. That's a mismatch the backers of the proposed Aequitas stock exchange want to change.
Aequitas is designed to be a "safe haven" from what its backers call predatory high-frequency trading strategies, the kinds of tricks that they say fleece long-term investors out of a penny here and a penny there. Soon it adds up to real money, as a professor at the University of California at Berkeley found when he used software to run one of those strategies. He made $377,000 in pretend profits trading shares of Apple for one day in May.
There is plenty of debate about whether high frequency is as bad as its detractors say, but little debate that many investors are spooked by being in the same marketplaces as traders they view as sharks.
For Aequitas to work, however, it needs regulators to bend a rule that has been a key part of the framework designed to keep trading fair. Regulators at the Ontario Securities Commission appear skeptical, even though they acknowledge that the rule may contribute to the problem as much as being part of the solution. And now Aequitas and its backers, which include huge institutions such as Royal Bank of Canada and IG Investment Management Ltd., are appealing for public support as they seek to sway the OSC.
The rule at issue results from the fragmentation of Canadian stock markets over the past decade from a single main market to a multi-market environment. The same stocks are trading at the same time on different systems. To ensure that an investor who calls her broker and says "Buy me some of that" gets shares of that company at the best possible price, regulators came up with what they called the Order Protection Rule. It says that trade has to happen at the market displaying the most advantageous price. For it to work, every trader has to have access to every marketplace. And that guarantees high-frequency traders access just the same as it does Joe and Jane Investor and their mutual fund and pension fund managers.
That's the rub, as Aequitas wants to ban high-frequency traders from making certain kinds of trades. All investors will be able to see the best bid and offer prices on Aequitas's so-called hybrid market. But only long-term investors will be able to act on them. For HFTs, it will be look but don't touch. If Aequitas is to go ahead as envisioned, regulators will have to concede that the rule as written has to change after just over two years in force.
It's worth it, says Greg Mills. The Royal Bank of Canada trading head, who is also chairman of Aequitas, calls the rule a "blunt instrument" that cannot adapt to the changes HFT is forcing.
"If the cost of HFT was well understood there would be public outrage demanding the fairness of the markets be restored," he says.
Mr. Mills' concern is not only that the OSC won't bend but that any decision could take years, just as the Order Protection Rule did. After long consultations, it was finalized in late 2009, and put into action in early 2011. By that time, the multi-market environment was already more than a few years old.
There are also fundamental questions about the order protection rule that boil down to this: Is it really protecting investors from unfair trading if it forces everybody into markets where HFTs are unchecked? And should investors be able to opt out if they believe they can do better without the protection, or they are willing to trade the guarantee of getting the best price for the knowledge that they are in an HFT-free zone?
Scott Penman, who oversees trading worth roughly $20-billion a year in Canadian securities as chief investment officer at IG Investment Management, says he's willing.
"There is a bit of a tradeoff," he said.
The OSC is certainly aware of the doubts about the rule. The regulator wrote in its request for comment on the Aequitas plan that "as a result of how the market structure has evolved, questions arise as to whether the intended outcomes have been achieved and at what cost."
The answer may be to simply let the market decide. Investors can choose for themselves whether they want to go to a market such as Aequitas, where they know they are trading the guaranteed best price for a lack of HFT competition. Of course, doing so would mean declaring the order protection rule obsolete after only a couple years, less time than it took to put in place.
If that's the case, the OSC clearly needs to pick up the pace of rulemaking. The OSC has pledged to hustle, saying it will "be as responsive, efficient and transparent as possible."
Here's hoping that means moving at market speed, not regulator speed.