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Why the OSC shouldn’t make high-frequency traders play by the rules

The OSC alleges Eric Inspektor, who headed the Kaptor Group of companies, raised money between 2005 and 2011 without ever being registered to sell securities and without issuing prospectuses or properly using accredited investor exemptions to sell to the public.

Peter Power/The Globe and Mail

Aequitas is a new stock exchange and trading venue looking for approval from the Ontario Securities Commission. Aequitas claims to offer investors protections against the trendy new villain of financial markets: high frequency traders. But the interactions between one of the OSC's regulations, the "Order Protection Rule," and Aequitas's policies make Aequitas look a little less than equitable.

The OSC is now asking whether it should exempt Neo, Aequitas' HFT-unfriendly exchange, from the OPR or whether it should apply a proposed new rule exempting exchanges that constitute less than 5 per cent of Canada's trading volume to Neo out of the gate. The answer to both of these questions is "yes" – the OPR should not apply to the Neo exchange.

Financial markets fund things in the real economy. Companies use prices in capital markets as a signal of where to invest. It follows that capital markets should efficiently and accurately price securities. To do this, capital markets need to be liquid and to accurately incorporate new information into prices. Good pricing should lead to good investment in the real economy and, for all of us, that's a good thing.

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There is a tension between informational efficiency and accurate price discovery. In essence, as more information gets incorporated into the price of a security, the more accurate that price is. This decreases an investor's incentive to devote resources to analyzing that security as the return to research is based upon deviations of the market price of a security from what a security's true price should be. Price discovery therefore best takes place in a somewhat inefficient market. This is the back of the envelope version of the Grossman-Stiglitz paradox.

This implies something of a high frequency trading trade-off. HFTs' bids are generally uninformed, and therefore relatively bad at reflecting new information that will be incorporated into a price, but HFTs do provide lots of liquidity. So, while HFTs may make it easier to trade and lower trading costs, they don't add much information to the market. Traditional traders tend to be very good at incorporating new information into a price but worse at providing liquidity. So, we want some amount of high-frequency trading to provide liquidity, but not so much as to chase informed participants from our markets.

In markets like Canada where securities trade across multiple exchanges, HFTs are particularly good at bringing the prices across exchanges together. By buying on the cheaper exchange and selling on the more expensive one, HFTs quickly cause prices to converge and earn a small profit doing so. That profit is the reward for providing liquidity.

As an investor, I may not like this process for obvious reasons. Like when you buy gas at one gas station only to find that it's cheaper down the road, it's not pleasant to find out that the stock you just bought for $5 is trading on another exchange for $4.98. While investors may like the liquidity that HFTs provide, they tend to dislike the fact that the HFT is pocketing that two cent differential. This seems unfair to some.

As regulators are wont do, they have made a rule about this. Canadian securities regulators, including the OSC, implemented the "Order Protection Rule," which requires that brokers direct trades to the markets that have the most advantageous price. This too comes with a cost. In particular, large investors bear the costs of monitoring exchanges, are charged subscription fees by exchanges and other compliance costs.

Of course, HFTs also benefit from the OPR. Through their speed advantage, HFTs move from one best price to another, still pocketing the difference in between, but doing so through the operation of the OPR. Large investors don't love this for obvious reasons. Not only do they incur extra costs under the OPR, but HFTs can still pick off their orders.

Onto this stage steps Aequitas and its novel proffer. On its "Neo" exchange, HFTs will face both fees and a "speed bump" that causes them to delay the execution of their trade and, presumably, nullifies a large portion of their speed advantage. Large investors will be able to trade in large batches without fear of being picked off by HFTs.

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There are obvious disadvantages to this fee. It doesn't serve to help liquidity, it doesn't help price discovery, it doesn't lower trading fees, so it mostly seems like it moves money from faster market participants to slower ones. Aequitas would argue that their Neo exchange is about more than cutting down tall poppies but is about resolving the Grossman-Stiglitz paradox in a way that's beneficial to investors; the exchange encourages fundamental analysis by offering informed investors a greater reward for their efforts.

Ideally, HFTs would opt out of participating in Neo. But Neo is what our securities regulations call an "open" exchange and subject to the OPR. When the Neo exchange is displaying the best price, HFTs will be forced to route their orders through Neo. Due to Neo's HFT penalties, in effect, HFTs will be forced to pay a "tax" every time their orders are routed to the Neo exchange.

There's little evidence that HFTs are currently crowding out fundamental analysis. If you believe that they are, however, then you want to weigh the increased incentive that investors have to engage in fundamental analysis due to an exchange like Aequitas against any decrease in liquidity caused by the exchange's policies. Similarly, if you think that the liquidity benefits of HFTs outweigh any potential negative informational effect, then you will be skeptical of exchanges like Aequitas that seek to limit high frequency trading. From either perspective, it doesn't make sense to mandate that participants enter a market in order to have them pay a fee without any benefit to liquidity or price discovery.

In other words, it's hard to see what regulatory policy end it serves to force HFTs to participate in the Neo exchange. Arguably, the exchange on its own simply adds to the amount of information in the market; HFTs can choose not to participate and large investors will be lured by, presumably, larger returns to their informational advantage. Forcing HFTs to participate through the OPR, however, increases the price of liquidity without offering commensurate benefits in the form of better price discovery.

HFTs may be unpopular, but if the OSC is going to subject them to regulations, they should make the market work better for the rest of us. Routing them through the Neo exchange does not.

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