Will new approach usher in unfairness?

In mid-August, the Ontario Securities Commission (OSC) published a preliminary proposal from Aequitas Innovations Inc. that is attracting strong support from some in the sector but withering criticism from others.

Supporters laud the plan to take back the markets from HFTs on behalf of long-term investors. But critics argue that the proposed approach will introduce its own forms of unfairness and invite greater fragmentation.

The pre-filing that the OSC published this past summer highlights several of the basic elements of the Aequitas vision that present novel issues for regulators and sector participants to consider.

For one, Aequitas plans to introduce a so-called “hybrid” book that would combine aspects of dark and lit trading, along with Aequitas’s own, more conventional dark and lit books. (See sidebar.) The proposed model also aims to restrict access to HFTs and would allow direct-access clients to function as market-makers.

Much of this proposal is new and untested, not just for Canadian regulators but in the world of equities trading in general, which makes it tough for regulators to evaluate. There are no existing examples for regulators and market players to look to in order to assess the possible impact on the Canadian markets if this approach is introduced.

“There is no data on which to base arguments about theoretical changes in market structure,” says market structure consultant David Lauer of Collingswood, N.J.-based Step Ahead Technologies LLC, in a comment on the OSC notice. “There is no analog to the hybrid market in other equity markets for comparison purposes. It is a dramatic departure when considered within the universe of dark and lit venues in Canada and elsewhere.”

Indeed, given that there’s no way to predict with any certainty just how Aequitas’s proposed vision would pan out in the real world, the central question for regulators is whether it’s worth the risk to let the market sort it out.

The one thing most commenters agree on is that it makes no sense to try to shoehorn the Aequitas proposal into the existing regulatory framework. Forcing the proposed model to conform to the prevailing rules on market structure will undermine the model’s efforts at innovation and is likely to create more market fragmentation and little differentiation.

If Aequitas’s vision is to be given a chance to work, either the rules will have to be changed or the new model will need exemptions from them.

Alternatively, regulators could try to change the rules to address the failings of the current markets, which Aequitas is seeking to address through its proposed model – such as the prevalence of HFTs and their perceived effect on market quality. However, that approach would face many of the same issues of uncertainty and the risk of unintended consequences. Moreover, it’s not clear that regulators share the concerns of Aequitas and its backers in the sector.

So far, there’s little in the way of conclusive, widely accepted evidence of the problems that Aequitas is seeking to address. However, the fact that buy- and sell-side firms are coming together in an effort to find their own solutions to these perceived problems indicates a widespread perception that these problems exist.

Support for Aequitas’s effort goes beyond the firms backing the model directly. In addition to the comment letters submitted on the OSC notice, Aequitas also gathered more than 100 votes of support from a wide variety of sources – including financial advisors, traders, fund portfolio managers and individuals – as signatories to form letters through both the Aequitas website and delivered directly to the OSC.

Along with all of the support for the initiative that’s reflected by the letter-writing campaign, there are more detailed comment letters that champion the Aequitas approach from the obvious candidates – firms that are part of Aequitas’s initial ownership group, such as CI Financial Corp., IGM Financial Inc. and Royal Bank of Canada.

On the flip side, the most ardent critics include firms with stakes in rival exchanges, such as CIBC World Markets Inc. and TD Securities Inc. (both of which were part of the group that acquired the former TMX Group Inc.), and firms that would be Aequitas’s direct rivals in the trading business.

Underlying these opposing positions are fundamental differences of opinion over what constitutes “fairness” when it comes to market structure. Critics of the Aequitas proposal contend that its efforts to curtail predatory HFT would violate the basic principles of fair access in markets. Supporters, on the other hand, contend that the current situation is unfair, as existing exchange models cater to HFTs seeking to exploit their fee structures, thereby harming market quality and the traditional, long-term investor.

CIBC World Markets’ comment says the proposed Aequitas model “contradicts many of the existing regulatory policy objectives of Canadian equity markets,” noting that the proposal blurs the line between orders that contribute to price discovery and those that free ride. The comment adds that the Aequitas model would discriminate between different types of investors: “As absolute values, which speak to core Canadian principles, fairness and fair access go beyond simple questions of market structure and must be defended. Opening the door to discriminatory practices may result in a beneficiary on one side, but leaves a victim on the other.”

The CIBC World Markets comment notes that Aequitas’s hybrid proposal doesn’t fit into either the existing rules for dark markets or lit markets. And, it argues, the proposal doesn’t offer enough benefit to the sector to justify a completely new regulatory framework. Moreover, the comment warns regulators that they should not set a precedent for allowing “selective, exclusionary trading practices, as this will be detrimental to the continued evolution of our markets.”

To the extent that the proposed hybrid book succeeds in attracting retail order flow, the comment adds, it could end up reducing investor confidence in existing visible markets: “We do not support the notion that a marketplace ought to be allowed to compete on a feature [or] characteristic that is unfair or may have a negative impact on market integrity or investor confidence, and we would urge regulation to curb that potential immediately.”

Similarly, the comment from TD Securities warns that introducing the proposed hybrid model to the existing regulatory framework risks further fragmentation and increased market complexity, as other marketplaces then may introduce their own models that restrict access to certain investors. These risks outweigh the potential benefits, the TD Securities comment suggests, insisting that the issues the Aequitas proposal aims to combat should be addressed through regulation first.

Supporters of the Aequitas proposal argue that the existing markets and regulatory framework are fundamentally flawed: much of the market’s apparent liquidity is illusory, long-term investors are disadvantaged and price-discovery mechanisms are distorted. Rather than relying on regulation to try to solve these disparities, the model’s supporters argue, these flaws can be addressed through competition and innovation, which, as RBC Dominion Securities Inc. notes in its comment, “often challenge[s] existing regulatory norms.”

Many of the other comments encourage the regulators to allow the experiment, albeit with some caveats. The Portfolio Management Association of Canada’s comment supports the Aequitas initiative, but notes that changes to market structure require oversight and accountability.

Other comments express support for what Aequitas is trying to achieve, yet question some of the plans – such as relying on short-marking exempt markers as a proxy for identifying HFT, allowing direct-access clients to serve as market-makers and giving market-makers the benefits of matching priority in markets in which they don’t also have corresponding obligations.

The submission from the Canadian Advocacy Council for Canadian CFA Institute Societies, which supports the overall aim of the Aequitas proposal, warns: “We do not believe that [direct-access] clients should be able to act as market-makers due to the significant systemic risk issues that this proposal would entail.”

Various comments argue that market-makers should remain under the direct supervision of Canadian regulators.

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