After regulators rejected Aequitas Innovations Inc.‘s initial plan for combating predatory high-frequency trading (HFT) activity, the firm went back to the drawing board. Its new approach is attracting widespread approval from investors, issuers and investment dealers.
The controversy over the impact of HFT on equities markets has been bubbling for several years now. Critics argue that ultra-high-speed traders have an unfair advantage, which essentially gives them a jump on slower traders and permits the capture of trading profits without contributing to price discovery, liquidity or overall market quality. Defenders of HFT argue that they do supply liquidity, which helps to lower spreads and boost market quality.
The debate over the impact of HFT is ongoing. The Investment Industry Regulatory Organization of Canada is hoping to have the results of its long-running study on HFT by the end of the year, which would probably guide any regulatory reform in this area. At the same time, the Canadian Securities Administrators (CSA) is contemplating a fundamental overhaul of market structure that aims to address some of the concerns about market quality that have emerged in recent years. The comment period for proposed changes to the order protection rule, among other possible market structure reforms, ends Sept. 19 (after Investment Executive‘s deadline).
In the meantime, an industry-driven response to HFT is in the works. Last year, Aequitas (which is owned by a consortium of buy- and sell-side firms and Aequitas employees) unveiled a proposed exchange model that aims to exclude HFTs entirely. After considering those plans, the Ontario Securities Commission (OSC) ultimately rejected the proposed model over concerns that it would violate the principle of “fair access.”
Aequitas now has a new plan that aims to address the OSC’s concerns. Rather than excluding HFTs outright, the new proposal aims to neutralize their speed advantage by introducing a random “speed bump” of between three milliseconds and nine milliseconds for so-called “latency sensitive traders” (LSTs). According to this proposal, these kinds of high-speed traders currently have an advantage of about five milliseconds over other automated traders when reacting to new market information – something the speed bump aims to eliminate.
Putting HFTs on a level playing field with ordinary human traders would require imposing a speed bump of about five seconds, according to the proposal. But, to avoid the unintended consequences of imposing this sort of delay, the proposal aims to equalize the speed of automated traders – and impose a relatively high transaction fee on LSTs that would make it uneconomical for them to try to generate profits by making millions of trades that each provide a tiny return.
This proposed approach is, once again, meeting with support from the industry. The comment period on the formal exchange application, which was filed this past summer, ended in early September. The vast majority of the feedback is positive.
Certainly, the concerns about the impact of HFT have not abated in the past year; if anything, they’ve grown. The issue has garnered wider public attention, particularly in the U.S. Without either regulatory intervention to combat HFT or approval for new trading models that seek to prevent it, some market participants worry that the markets will be fatally damaged.
As legendary fund manager Eric Sprott, chairman of Sprott Inc., warns in his comment on the Aequitas proposal: “I know in my gut that HFT is the death knell of markets … it’s time for the industry to take it to heart. We don’t have markets, we have manipulation … The retail and institutional investors know it and they are leaving this obviously rigged market.”
Aequitas’ proposal, Sprott’s comment continues, “is offering the industry commercial solutions to take matters into our own hands. Solutions, if enabled effectively, [that] will see the average Canadian investor come back into markets.”
That sentiment is echoed in many of the other comments on the proposal, which convey worry about the impact of HFT and suggest that Aequitas’ proposal will work. (As with any untested trading model, it’s not certain that this approach will succeed; the only way to find out is to try it.)
Praise for Aequitas’ plans is far from universal, however. Critics of the proposals warn that it will fragment the markets further and that the proposed model is complex. Critics also say the proposal still raises issues of fairness and needs to be more transparent about how some of its features will work.
Central to these criticisms is the plan to impose speed bumps and higher transaction costs on traders that are deemed to be LSTs. Some critics worry that defining LSTs will be difficult, as will drawing a distinct line between LSTs and more conventional traders. Several comments suggest that traders could attempt to game the distinction between LSTs and ordinary traders, which could undermine the benefits of the proposed model and give ordinary investors a false sense of security.
There also are worries that the proposed approach would set a precedent for discriminating between types of traders. TMX Group Ltd.‘s comment, for one, notes that while it sees the imposition of a speed bump rather than imposing an outright access ban on HFTs as a “move in the right direction,” imposing a speed bump on a particular type of account or trader “continues to raise fair access concerns.”
Moreover, there’s worry that introducing yet another fledgling trading venue (which envisions offering four new trading books) will impose further costs on the industry for routing technology, connectivity and the testing required to integrate Aequitas’ proposal with the existing market.
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