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Regulator raises questions about Aequitas exchange proposal

The OSC has alleged the Ernst & Young audit of China’s Zungui Haixi was not in accordance with generally accepted auditing standards.

Peter Power/The Globe and Mail

The Ontario Securities Commission has some serious questions about a plan to create a new exchange in Canada designed to eliminate what its proponents say are pernicious practices of high frequency traders.

The planned exchange, known as Aequitas, has some powerful backers. Proponents include Royal Bank of Canada and the mutual fund giant IGM Financial.

The new market is envisioned as a collection of sub-markets, each with different rules to encourage and discourage different kinds of trading behaviour.

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The OSC came out Tuesday with a list of questions about the Aequitas plan, as part of a request for comment from market users.

Most of the questions involved the so-called hybrid market, an innovation of Aequitas designed to bridge the gap between more traditional "lit" markets where bid and ask quotes are displayed for all to see, and a "dark" market where bid and ask prices are not shown.

Concerns ranged from the inaccessibility of some parts of the market to some investors to plans to give preference to market makers to encourage them back into the market. The OSC says at one point that "if Hybrid proceeds in its current proposed form, it may necessitate deviating from a number of regulatory principles and objectives that have been fundamental to the development of the current regulatory framework for visible and dark markets."

Below are some of the main questions and concerns.

1. The regulator is concerned the hybrid market Aequitas proposes will show prices that won't be accessible to all investors. The regulator has worked under a framework that says investors should be able to access the best possible price for a stock in Canada, no matter which market it is on. By barring some investors from the hybrid market (those that are not long term investors, denoted by a special marker on their orders), Aequitas would be bending that framework. "An underlying principle of OPR [order protection rule] is that all visible orders will be accessible to all parties. This is key to having an effective order protection rule – without accessibility, investor confidence may be hampered because of the potential for confusion about why the best prices were not in fact executed. By showing the volumes at the NBBO or better but not providing access to all, Staff do not think that the proposal is consistent with this important principle."

2. The regulator is also questioning whether the plan by Aequitas to give incentives to so-called market makers will hurt other investors. Market makers have a long history in stock markets, offering a service where they stood in to buy or sell certain stocks they were responsible for when nobody else was willing to do so. The business of market making has gotten very tough in recent years, and most traditional market makers have dropped out because they can't make money. Aequitas envisions allowing market makers to move up the queue, jumping in front of other traders in some cases, to ensure they have access to the buy and sell orders they need to make money. On that, the OSC said that "in the context of fairness and its impact on investor confidence, Staff note that Aequitas' proposal for market makers to receive priority in matching could negatively impact investor confidence if the likelihood of an investor achieving a fill on its passive order is diminished because it is too far down the line in terms of priority, behind both broker preferencing and market makers. Priority for market makers might therefore contribute to an increased likelihood that natural investors will be crowded out at the quote."

3. Aequitas also plans to enable some market users known as non-registered direct electronic access [DEA] clients to act as market makers. Non-registered DEA clients fall into a regulatory grey area, because they are not registered as brokers with Canadian regulators. Instead, they access markets through investment dealers who are registered. The OSC said bluntly that "the proposal for non-registered DEA client market makers is not consistent with our expectations regarding regulatory oversight of market makers." The issue is that market makers, because of their "roles and responsibilities, and the benefits received in exchange, it has been expected that market makers for equity securities be registered with the securities regulatory authorities, directly regulated by IIROC for compliance with IIROC rules, and members of the exchange for the purposes of monitoring and regulating market making obligations. The oversight that results is, in our view, important to ensure that a market maker lives up to its obligations for which benefit is being provided, and that it does so within the rules and construct of the regulatory framework." Aequitas has mooted the idea of ensuring that DEA market makers must be a market maker on an existing exchange, but the OSC said it is "questionable how these are suitable proxies for IIROC membership in this regard, as the foreign regulator and/or other exchange may not have rules or compliance requirements applicable to its registrants/members when trading via intermediaries on foreign markets."

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4. The effect on the visible market, where stock prices are displayed and investors get their information on what shares are worth, is also a concern. The hybrid market proposes low trading fees, which might push a lot of so-called active order flow (also known as market orders) to the Aequitas hybrid markets. That may degrade the price discovery function of existing visible markets, and also leave the passive orders (a.k.a limit orders) on those markets facing a disproportionate amount of HFT strategy driven active trading that can not go to the hybrid market. "As a result of all of these incentives, there may be a risk that Hybrid will attract a significant amount of active order flow (which might be "uninformed" retail order flow) away from the price formation and price discovery mechanisms of the traditional visible markets. This may have the result of exposing the passive orders in those markets to a higher proportion of trading strategies that Hybrid is designed to avoid, or to a higher risk of adverse selection. To the extent the above-noted risks materialize, we question how this might affect investor confidence in the quality of the visible market as a whole, their continued willingness to post limit orders, and what the resulting potential impact might be on liquidity and the efficiency of the price formation and price discovery process."

(Boyd Erman is a Globe and Mail Capital Markets Reporter & Streetwise Columnist.)

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