A tiny trading venue run by Canada's largest market operator is facing scrutiny from Down Under.
TSX Alpha, one of two stock markets in Canada that intentionally slow down some orders through a so-called speed bump, is doing more harm than good for Canadian investors, according to a report spearheaded by a professor at the University of Sydney. The report's findings are adding fuel to a debate that has been raging on Bay Street between those who love the trading venue and others who love to hate it.
The concept of a speed bump, which was famously profiled in the book Flash Boys, has been pitched as a way to protect retail investors from being preyed on by much quicker high-frequency traders (HFT), but there's no consensus on whether they work.
TMX Group Ltd. relaunched its Alpha venue last year with a speed bump in order to keep retail order flow in Canada. But the study, entitled The Value of a Millisecond, found that Alpha favours fast traders who are willing to pay more for preferred access. At the same time, the study says Alpha makes it more expensive for large pension and mutual funds in Canada to manage their clients' portfolios and harder for their stock brokers to execute these orders.
University of Sydney finance professor Sean Foley, the study's lead author, estimates that Alpha has added roughly $105-million in extra costs to the Canadian equity markets since its speed bump model was introduced in September, 2015. "If you read the Alpha material, it says 'We're trying to protect people from predatory HFT.' And it's like 'Really, or are you trying to facilitate predatory HFT?' Because that's what it looks like," Prof. Foley said in an interview.
TMX says it's "highly skeptical" of the paper's conclusions, adding that "there are significant flaws in the approach taken" and the findings could be attributed to multiple changes that took place around Alpha's launch. "We built Alpha to have a very specific value proposition," said Kevin Sampson, managing director of equity trading at TMX. "Those who don't find value in the model are not required to trade on Alpha" since the venue is excluded from the order-protection rule, which requires brokers to route their clients' orders to the venue that shows the best price for a security.
The study uses public data rather than data from the regulator. Its methodology is also being criticized by at least one academic, Andreas Park of the University of Toronto, one of Canada's leading experts on market structure. "There's a question about whether or not the guys who manage retail flow are negatively affected. I would say the jury is out on this one."
Prof. Foley presented his findings to the Ontario Securities Commission last week, but the regulator said it would be premature to comment on the study. The OSC continuously monitors Alpha as part of its approval process.
"The paper raises some significant issues that we are still considering," said Susan Greenglass, director of market regulation at the OSC. "We have been receiving data from Alpha and performing our own work about the impact of the model and Prof. Sean Foley's paper is an input in our analysis as we continue our review."
Alpha is relatively small, handing roughly 6 per cent of total trading by volume in September. It was created to attract retail order flow through a fee structure where Alpha pays retail brokers a rebate for sending their clients' market orders to the trading venue.
Retail trades are small and tend to be less correlated with future prices. As a result, several markets in Canada have tried to structure themselves in such a way that attracts more lucrative retail flow to leave the main market.
Retail investors are not always aware of how their orders are being routed when they use discount brokerages. This is putting pressure on regulators to act because other trading venues are trying to emulate parts of Alpha's model.
"If you strip out that uninformed order flow from the main market, then all you got left is sharks," Prof. Foley said. "If there are too many sharks and not enough fish, sharks don't eat each other. It gets bad."
The Alpha speed bump works by randomly delaying almost all orders that are sent to it by between one to three milliseconds. (It takes 300 milliseconds to blink your eyes.) Traders can bypass this seemingly unnoticeable delay through one order type known as "post-only," which are standing orders often posted by so-called market makers. These traders pay higher fees to Alpha for the right to enter and cancel these limit orders and gain an edge by avoiding the random delay.
One to three milliseconds is enough time for the fastest traders to survey the rest of the market and decide whether they should keep their order in play. The study found that market makers on Alpha often cancel their limit orders when they see a more sophisticated order barrelling towards theirs.
Traders complain regularly about quotes that disappear on Alpha, says Patrick McEntyre, the managing director of electronic trading and services at National Bank Financial: "That's frustrating but it's the reality." (TMX says quote fading happens on every venue.)
At first, Mr. McEntyre was skeptical about the study. But his concerns were put to rest after Prof. Foley spoke about his findings last week at a mid-day event hosted by Aequitas Innovations Inc., the company that operates Canada's other speed-bump market.
Mr. Foley's findings haven't come as a surprise to many brokers. "That is what it was designed to do and what we all knew it was going to do," said Rizwan Awan, head of quantitative execution services at BMO Capital Markets. "What was surprising was that it was actually allowed to go through."
Like many on Bay Street, he's seeking clarity from the regulators, saying: "That is where we have to take a step back and figure out what is good for the marketplace as a whole."