“We’d all sit there and stare at the screen and I’d have my finger over the Enter button. I’d count out loud to five….
‘Two…..See, nothing’s happened.
‘Three…..Others are still there at forty-eight…
‘Four…Still no movement.
‘Five.’ Then I’d hit the Enter button and — boom! — all hell would break loose. The offerings would all disappear, and the stock would pop higher.”
At which point, he turned to the guys standing behind him and said, ‘You see, I’m the event. I am the news.’ ”
This short excerpt from Michael Lewis’s Flash Boys details Canadian Brad Katsuyama’s “a-ha moment.” Katsuyama, a trader working for RBC Capital Markets in New York, realized that his trades were being front-runned by High-Frequency Trading (HFT).
The phenomenon was happening all over Wall Street as large institutions had their orders filled by 13 different exchanges. HFT was taking advantage of the microseconds that it took for these orders to be filled across these marketplaces. In order to provide a comprehensible breakdown of how it was happening, Canadian Business magazine created a succinct video so easy to explain children can understand it.
Katsuyama’s work uncovered how the proliferation of exchanges and the creation of dark pools took advantage of the average investor by adding fractional costs to each trade.
Collectively, they amounted to a tax on trading that HFT traders and brokers collected as trades were routed to exchanges with a kickback fee structure. Katsuyama developed a way to prove that the exchanges, large banks and HFT were manipulating the system for their advantage, much to the outrage of other market participants who discovered it.
HFT also helps explain, to some degree, the proliferation of exchanges in Canada. There is the TSX, Alpha, Chi-X, CX2, Pure, CSE, Omega, TriAct and Lynx. All these exchanges purported to create a more competitive environment, but many were created to protect large institutions from predatory trading on their large orders. Over time, this has eroded investor confidence and failed to deliver the cost savings, transparency or a clearer picture of the market that competition is supposed to bring.
Instead, it has delivered the opposite, with new data feeds and connections from exchanges to be paid for, higher trade costs and opaque markets. Exchanges are the original source of crowdsourced capital but more and more they are misallocating capital based on fee structures that benefit brokers and erode the average investor’s confidence in public markets.
In America, Katsuyama’s answer to this was the IEX exchange, which slows down trades and ensures that trades are routed according to the best offer or bid out there. There is also a Canadian exchange, Aequitas NEO Exchange, designed to combat the problem. It’s headed by Jos Schmitt, formerly of the Alpha Group.
On Nov. 12, 2015, the Aequitas CEO sat down with members of Toronto’s financial community for breakfast at the Royal York Fairmont to present the Aequitas case. Schmitt echoed many of the concerns that Michael Lewis documented in his book.
The value proposition of Aequitas directly addresses the concerns of large institutions and investors by increasing competition, improving transparency and reducing HFT predatory strategies, Schmitt said. The result is a more honest and transparent marketplace. The NEO Exchange offers competition along three lines – trading, listings and market data.
Aequitas’s platform creates a speed bump for HFT traders and a fee structure that emphasizes the quality of execution with “long term traders.” Aequitas offers a technology platform with a simplified integration of routing technology – a latency normalization feature to counter certain types of HFT predatory strategies.
In other words, it has the technology to slow down orders so if the order is filled across multiple exchanges, your order will reach all the exchanges at the same time. That eliminates front-running by those with a technological speed advantage.
Aequitas also focuses on helping create liquidity by limiting HFT predators and supporting “true” market makers. Market makers will provide a liquidity safety net for TSX, TSX-V and Aequitas listed securities.
One caveat: Schmitt feels there are many publicly listed companies out there that should not be listed or are not ready for the public market, which acts as a drag on the stock due to listing fees and lack of investor interest.
Aequitas will seek listings through a simplified process for companies that they deem ready for the public markets. Schmitt stated clearly that they will not be accepting Venture listings for the time being. This does not mean they will ignore these listings, he said: they are working on an alternative solution for raising capital with secondary liquidity.
One of the problems Aequitas hopes to help solve is the lack of transparency in the markets. Many investors who are clueless how their orders are filled fall victim to HFT strategies and end up paying more their trades. The data is available but the price is prohibitive to the average investor.
That fuels distrust because there is not complete access to what is happening to a particular stock. Often many discount brokerage accounts do not offer a complete picture of the true volume of a stock. Unless you have a Bloomberg terminal or a broker, there is little chance for the retail investor to get the complete picture. Stockwatch is one service that does provide complete volume for all exchanges in Canada, for a fee of course.
Aequitas has large institutional support from Barclays Corp. Ltd., BCE Inc., CI Investments Inc., IGM Financial, ITF Canada Corp., OMERS Capital Markets, PSP Public Markets Inc. and RBC Dominion Securities Inc., which each own stakes ranging from 10% to 15% of the parent company, Aequitas Innovations Inc.
Even a longtime ambassador of the Canadian mining community has voiced his support, in a quote in the new exchange’s marketing material.
“I have a distinct feeling that the capital markets in Canada are no longer fair, transparent and efficient and that the big losers are most investors and capital-raising corporations … One possible solution is presented by the Aequitas NEO Exchange. Their proposed new exchange is the first exchange that I am aware of that seeks to tackle the issues that are affecting the role of exchanges in facilitating the economy. It seeks to bring the exchange business back to its fundamental purpose of facilitating, in the most efficient way, the allocation of investor’s capital to capital seeking corporations.”
Robert McEwen, McEwen Mining
Brad Katsuyama noted that in America, the proliferation of exchanges facilitated predatory trading – making it difficult to see how another exchange could solve the problem. However, the hope here is that by exposing the predatory strategies with a defence against them, more and more investors and large institutions will ask for their orders to be routed through the honest marketplace – if not for the sake of long-term market confidence, to avoid being gouged.
Innovation is needed in Canada’s capital markets in order to attract capital and investors to great businesses. This may not be the final solution but Aequitas’s efforts will hopefully reveal that honesty and transparency can build better markets, companies and wealth.
Another of Michael Lewis’s books, The Big Short, is coming to the big screen next month. It features Brad Pitt, Christian Bale, Selena Gomez, Ryan Gosling and Steve Carell and was panned by Business Insider in a recent (brief) review.
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