Big questions surround new exchange

In mid-August, the sector got its first glimpse of what Aequitas has in mind when the Ontario Securities Commission (OSC) published a notice outlining the details of a “pre-filing” by Aequitas for a 45-day comment period.

Aequitas has not yet applied for permission to operate as a stock exchange, which it aims to launch by the end of 2014. Instead, the OSC notice sets out Aequitas’s basic vision but doesn’t get into the details that would be covered in a full application, such as governance and listing rules.

For now, the OSC is canvassing the market for feedback on Aequitas’s basic plan and is highlighting some of the public-policy issues the regulator foresees.

According to the notice, there are a couple of core aspects of Aequitas’s plan that may raise regulatory issues: chiefly, the plan to introduce a so-called “hybrid” book combining aspects of “dark” and “lit” trading, in addition to dark and lit books; and the proposed approach to market-making, which would include giving market-makers trading priority and allowing direct electronic access (DEA) clients to function as market-makers.

These features raise a number of concerns for the OSC, including issues of fairness and market integrity. For example, the OSC notice indicates that the hybrid model would lead to further segmentation of order flow, which raises questions about fair access. As well, the OSC notice wonders about the model’s potential impact on market quality and integrity.

These issues arise primarily because the proposed hybrid book is a new animal that shares features of both lit and dark books. According to the OSC notice, the hybrid book would be similar to Aequitas’s dark book: both would allow only “long-term investors” to take liquidity, and both books would trade at or within the national best bid and offer (NBBO).

However, unlike the purely dark book, the hybrid book would display the available liquidity that’s within the NBBO. (There would be no pre-trade transparency for orders outside that range.) And, unlike the purely lit book, neither the hybrid nor the dark book would offer a so-called “maker-taker” fee model, although the exact fee structure that Aequitas is planning to use has not been revealed yet.

The OSC notice spells out several possible issues with this proposed structure. For instance, Aequitas’s efforts to guard against predatory HFT strategies and allow only long-term orders to trade on the hybrid market will lead to further segmentation of order flow. Furthermore, this policy could allow for orders to be “traded through” – something the regulators have tried to curb by adopting the Order Protection Rule in 2011.

That rule aims to ensure that visible, better-priced orders trade before orders with worse prices in an effort to protect market quality and instil confidence in the integrity of the market. But, as the OSC notes in its notice concerning the Aequitas proposal, the proposed hybrid model wouldn’t allow excluded orders (such as an HFT order) to trade with best-priced orders in the hybrid book; instead the former would be routed to inferior prices on other markets. This may violate the rule’s underlying precept that all visible orders be accessible to all traders.

“This is key to having an effective Order Protection Rule,” the OSC notice says. “Without accessibility, investor confidence may be hampered because of the potential for confusion about why the best prices are not in fact executed.”

As a result, the notice says, the hybrid approach isn’t consistent with the principle underlying the Order Protection Rule. The notice also questions how the rule should be interpreted and how it would apply to the hybrid book.

Similarly, the OSC notice says, principles of fair access may be violated by the hybrid model, in that regulators generally have required that all visible markets be accessible to all traders. Dark markets are permitted to restrict access to certain types of traders on the basis that their orders aren’t subject to order-protection requirements, among other things.

But Aequitas’s hybrid book proposes to offer some pre-trade transparency but also restrict access to long-term traders. Thus, the OSC questions whether this approach is consistent with the basic principle of fair access for visible markets.

Aequitas has issued responses to some of these issues, acknowledging the regulator’s concerns but also making the case that its exchange should be allowed to operate this way. Aequitas says its hybrid book proposal is “an innovative trading solution that prohibits predatory trading activities and promotes quality resting liquidity while respecting the spirit of existing regulations.

“The fact that it is innovative and does not fit an existing rule set,” Aequitas argues, “should not preclude market participants from benefiting from it.”

As for questions about whether the hybrid proposal violates “fair access” principles, Aequitas says, this standard is not an absolute and “limiting access should not be considered unreasonable when it supports market quality and addresses harm in the marketplace.”

The OSC also is questioning whether a hybrid book that protects orders from predatory trading strategies and charges low fees could end up being too successful – attracting too much order flow away from other visible markets, thereby undermining the efficiency and price-discovery function of those markets and leaving the traditional visible markets even more at the mercy of predatory trading strategies.

Aequitas’s proposed hybrid structure doesn’t fit neatly into the existing regulatory model, so the OSC wonders whether the model should be changed or if Aequitas should be pressed to conform to the existing framework and principles.

Aequitas argues that its proposal is an opportunity for innovation. Although the consortium concedes that wider bid/ask spreads may result if the proposed exchange is successful, Aequitas maintains that the current market is beset by predatory trading strategies and, thus, the advertised spreads are not the actual spreads. Therefore, wider but more genuine spreads will benefit the market overall, leading to more reliable prices and less intraday volatility.

However, Aequitas’s proposed hybrid book isn’t the OSC’s only concern. The regulator also is questioning the proposed approach to market-making, including whether the plans to give market-makers’ orders priority also may raise issues of fairness, which could harm investor confidence.

The OSC also is questioning Aequitas’s plans to allow unregistered DEA clients to serve as market-makers. The OSC suggests that this approach would allow unregulated traders to gain the benefits that come from the market-making role without being subject to the same level of oversight as traditional market-makers – the registered investment dealers – are. The OSC notice asks whether this would create an unlevel playing field between traditional dealers and DEA clients.

Aequitas believes that allowing DEA traders to serve as market-makers will benefit overall market liquidity, as long as they are subject to appropriate oversight and sponsored by a regulated dealer.

Overall, according to Aequitas’s response, the regulators should facilitate innovation, albeit with accountability – including reporting to and oversight by the regulators: “Such [an] approach allows innovation and change while managing potential risks.”

The OSC notice indicates that while the regulator “strongly support[s] innovation and competition in the Canadian marketplace,” it will also have to evaluate any proposed exchange to ensure it complies with the principles and goals of the existing regulatory framework.

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