The Ultimate Best Execution Conflict of Interest

The Ultimate Best Execution Conflict of Interest
exemplifies the need to recognize not all speed bump markets are created equally.

by Jos Schmitt, CEO, Aequitas NEO Exchange

I am regularly asked how I feel about the TMX replicating some of our innovative solutions.

The answer is “surprised”. Not by the actions of the TMX, but surprised about industry stakeholders not seeing through the TMX rhetoric.

Let’s focus on one specific example: the concept of a marketplace speed bump.

The Aequitas NEO Exchange announced the concept of a speed bump in early 2014, with the filing of its Exchange Recognition application. It was the result of substantial dialogue with the industry and regulators throughout 2013. Our objective is simple: curb predatory high frequency trading (“HFT”) and provide equal execution opportunities for all investors.

Subsequently, in a white paper released in October 2014, the TMX announced its own speed bump for the Alpha marketplace, claiming it would address “three significant issues that require our attention and action: Canadian order flow is migrating to the United States (U.S.); technology-driven markets are not optimized to serve all; and market complexity is on the rise”.

Let’s now dig a little deeper and perform a thorough comparison between the two speed bumps.

How does the NEO Exchange speed bump work?

We designed the NEO Exchange speed bump to counter a well-known predatory HFT strategy: technological front-running. Whereby predatory HFT firms leverage speed at the microsecond level, in a fragmented marketplace environment, to take advantage of long-term investors. Here is one example of how this strategy can work:

1. An HFT firm places small orders across multiple marketplaces, often in a layered fashion, at prices that set the National Best Bid and Offer (“NBBO”), knowing everyone else will be forced (in compliance with the order protection rules) to trade with these orders first;
2. Once one leg of a larger Long-Term Investor (“LTI”) order trades with one of the small HFT orders, the HFT firm leverages its speed advantage to receive the information about this trade before anyone else; and
3. The HFT firm uses this information and the knowledge that the LTI order will next try to trade on certain other marketplaces (again, in compliance with the order protection rules) to technologically front-run that incoming LTI order by:
   • Taking out genuine resting orders on those other marketplaces;
   • Canceling and/or re-pricing its own orders;
   • Trading with the slower incoming remaining legs of the original LTI order.

Results: gain and no risk for the HFT firm, a less favourable price for the LTI.

The NEO Exchange speed bump curbs this type of predatory strategy by delaying the speed at which an HFT firm can take out resting orders on one of the marketplaces the NEO Exchange provides. Moreover, as a beneficial consequence of the order protection rule, HFT firms cannot circumvent the NEO Exchange speed bump marketplace. This causes undesirable unpredictability that negatively impacts technological front-running across the entire Canadian market. By leveling the playing field, the NEO Exchange speed bump benefits LTIs as well as the HFT firms that do not utilize these types of predatory strategies.

How does the TMX Alpha speed bump work?

The TMX Alpha speed bump applies to all orders, in other words everyone is slowed down, with one exception: Post Only orders (see Section 4.12 of the TMX Equity Markets Order Types and Functionality Guide).

What is a Post Only order? An order feature that leads to “rejecting an order upon entry when it is otherwise immediately executable” (see Section 3.5 of the TMX Equity Markets Order Types and Functionality Guide). In simple terms, it is an order that gets rejected upon entry if it were to trade.

Who uses Post Only orders? HFT firms who have the technological capability to leverage them. It would be fair to say that this type of order is unknown to the vast majority of other industry participants. A few months ago I asked an audience of over 100 institutional traders about their familiarity with Post Only orders, not one had ever used this type of order!

By not subjecting the Post Only orders to its speed bump, TMX Alpha is protecting HFT firms – those who already have a speed advantage! It should not be a surprise considering the fact that the TMX Alpha speed bump was designed with the help of an HFT firm. Doesn’t this remind us all of a recent case involving Direct Edge?

Just to be clear, I am not against Post Only orders and most markets support them, including us. When used for its intended purpose, it is a useful tool for market makers to fulfill their role to support reliable liquidity. Market makers are there to provide liquidity for others to interact with and not take away liquidity that is already there. Unfortunately, in the case of TMX Alpha they are used to identify who should get the benefit of being protected by the speed bump.

The ultimate best execution conflict of interest?

But there is more. The fee structure of the TMX Alpha marketplace is an inverted fee structure. This means liquidity providers (speed-bump protected HFT firms) will have to pay to place their orders, while liquidity takers (dealers representing long-term investors) will be paid a rebate to take liquidity. This leads to an obvious conflict of interest:

1. Dealers are incentivized by the rebates to send their liquidity-taking client orders to TMX Alpha; and
2. Predatory HFT firms are enabled, more than ever, to technologically front-run these speed-bump impacted client orders (not surprising that they are willing to pay for this privilege).

Let’s analyze two examples of what could happen:

I am an institutional investor, an investment advisor with a large order for multiple retail investors or a retail investor with a large order seeking to buy 10,000 shares

1. There are 5,000 shares on offer at the National Best Offer (“NBO”) price on marketplace A (including 100 entered by a predatory HFT firm), there are 5,000 shares on offer at the NBO price on marketplace B (including 100 entered by a predatory HFT firm) and there are 5,000 shares on offer at the NBO price on TMX Alpha (all entered by a predatory HFT firm using a Post Only order);
2. My dealer, incentivized by the TMX Alpha liquidity-taker rebate, will split my order of 10,000 shares and send 5,000 shares to TMX Alpha and the other 5,000 shares to marketplace A;
3. My order gets executed on marketplace A, where the HFT firm trades 100 shares of the 5,000; this allows the HFT firm to know that more orders are to come and most probably on TMX Alpha because of the incentive to the dealer;
4. The predatory HFT firm leverages its speed advantage to take the shares on marketplace B and has all the time in the world, knowing that everyone else on TMX Alpha is slowed down by the speed bump - including my order, to adjust its non-delayed Post Only order leading me to trade at a less favourable price.

If my dealer used a limit order rather than a market order, I may not have traded at a less favourable price on TMX Alpha, but by now all markets moved away from me.

Conclusions:

• My large order was detected and technologically front-run by the predatory HFT firm leveraging speed and the additional protection of the TMX Alpha speed bump;
• Best execution was not achieved.

I am a retail investor with a small order of 500 shares

1. There are 5,000 shares on offer at the NBO price on marketplace A (including 100 entered by a predatory HFT firm), there are 5,000 shares on offer at the NBO price on marketplace B (including 100 entered by a predatory HFT firm) and there are 5,000 shares on offer at the NBO price on TMX Alpha (all entered by a predatory HFT firm using a Post Only order);
2. My dealer, incentivized by the TMX Alpha liquidity-taker rebate, sends my 500 share order to TMX Alpha and doesn’t worry about the detection that large orders may be subject to (see my example above) because it should be executed in one time;
3. While the speed bump delays my order on TMX Alpha, the market moves against me and the predatory HFT firm adjusts its non-delayed Post Only order leading me to trade at a less favourable price.

Again, if my dealer used a limit order rather than a market order, I may not have traded at a less favourable price on TMX Alpha, but at this point all the markets have moved away from me.

Conclusions:

• While my order was locked in by the TMX Alpha speed bump, the predatory HFT firm had the time to observe what is happening in the Canadian market overall and decide whether to trade with me at the original price, a worst price or not trade at all;
• Best execution was not achieved.

Think now about the position my dealer was put in. Sending order flow to TMX Alpha provides rebates that represent substantial revenue flows, but sending order flow to TMX Alpha will frequently lead to best execution issues. This is the "ultimate best execution conflict of interest".

The regulators acknowledged issues with the TMX Alpha speed bump

The TMX Alpha speed bump proposal was put forward by the regulators for industry consultation in November 2014. The comment letters raised many concerns including the best execution concerns I expressed earlier. A good example is the Canadian Security Traders Association comment letter, a neutral organization balanced in its considerations.

Subsequent to this, and without any further consultation, the regulators decided that the TMX Alpha marketplace with its speed bump was approved. However, it was approved with a number of conditions, including the fact that it needed to become an “unprotected marketplace”. This means that dealers will not violate order protection rules when they ignore prices proposed on TMX Alpha that are better or equivalent to the NBBO.

Why have the regulators decided to approve Alpha as an unprotected market? There is a high best-execution risk with sending orders to Alpha and regulators must have believed that it would be inappropriate to force dealers to send their orders there. This, however, does not eliminate the best execution conflict of interest issue and may lead to a number of very troubling unintended consequences:

• Institutional order flow, where the investor is sophisticated and aware of the best execution risks, avoids TMX Alpha;
• Retail order flow, where the investor has no say where orders go, prioritizes TMX Alpha;
• Deep segmentation of Canadian order flows, negatively impacting the overall price formation process to the detriment of both investors and issuers;
• Substantial costs for the dealer community to manage an environment where there are both protected and unprotected lit markets;
• Substantial legal and reputational risk for the dealer community exposed to the “ultimate best execution conflict of interest”; and
• Substantial order flow migrating to the US driven by sophisticated investors concerned about the “ultimate best execution conflict of interest” that now haunts the Canadian market.

These unintended consequences are further exacerbated in Canada by the lack of any clear and quantifiable metrics for judging best execution, and by the lack of any mechanisms to monitor it. I discussed this in a recent blog post.

Meanwhile in the US markets, where there is an obligation to produce best execution metrics, we see increased concerns about the incompatibility between dealer rebates and best execution:

• Retail best execution statistics, released last month by the Financial Information Forum, have raised new concerns;
• A March 2015 academic paper, “Can Brokers Have It All? On the Relation between Make-Take Fees and Limit Order Execution Quality” by Battalio, Corwin and Jennings, suggests that “order routing designed to maximize liquidity rebates does not maximize limit order execution quality”.

We can expect that this will lead, in the US, to increased regulatory scrutiny on best execution practices and probably new litigations and fines. In Canada, the probability of facing our own first major case will increase considerably with the advent of the new TMX Alpha marketplace model.

Conclusions

First and foremost, I believe that by now it should be clear not all speed bumps are created equal.

When assessing the TMX Alpha speed bump and overall market model against TMX’s publicly stated intentions, I don’t see any correlation:

• It does not address the issue of “Canadian order flow … migrating to the United States” - On the contrary, it will probably have the exact opposite impact whereby sophisticated investors (both institutional and retail) concerned by the “ultimate best execution conflict of interest”, will request their dealers to send more flow to the US (maybe not a perfect market either, but a market where best execution transparency is much more developed);
• It does not address the issue of “technology-driven markets … not [being] optimized to serve all.” On the contrary, it is a model that is even further biased towards predatory HFT; and
• It does not address the issue of “market complexity … [being] on the rise.” On the contrary, it will lead to a level of uncertainty and chaos never experienced by the Canadian dealer community.

What can we do about this? My suggestions are as follows:

• Ask the TMX to put the interests’ of investors and issuers first by rejecting a market model that will be detrimental to them;
• Leverage the CSA consultation paper “Application of the Order Protection Rule to Marketplaces Imposing Systematic Order Processing Delays” to express your concerns about the TMX Alpha market model, and to request that, before any further regulatory tinkering with market structure takes place in Canada, we put in place a well-defined, measurable and enforceable best execution framework. For further details please consult the position paper the Aequitas NEO Exchange issued last month: “Not All Speed Bump Markets are created Equal - Unintended Consequences, Conflicts of Interest and the Chaos that will stem from a partial Order Protection Rule” (comments on the CSA consultation paper are due today but we expect that, considering the summer period, the CSA will grant some leniency); and
• Ensure that industry stakeholders are aware of the upcoming changes so they can make the right choices going forward.

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