The opportunity to serve Individuals’ and entrepreneurs’ participation in the stock market must be earned. And earning that opportunity begins by demonstrating to them that we respect their commons in the first place. To the benefit of us all, our children and our children’s children.
NOTE TO READER – This prepared speech is included in its entirety. Highlighted sections were not delivered due to TMX guidelines regarding allotted time. As well, certain punctuation is used to convey the Speaker’s use of emphasis (caps) or tone (underline) in the oral delivery.
The Commons
The cod off the coast of the Grand Banks of Newfoundland are gone now. Fish are so rare; experts doubt they can ever recover. Communities have been driven into decline, families facing hardship for generations. Fishing has essentially been banned, as the Newfoundland fishery collapsed and was effectively closed by the Canadian government in the 90s, in order to save a species that was once so plentiful that Viking civilizations crossed the Atlantic to help found this Nation. “So thick by the shore we hardly have been able to row a boat through them.”
For centuries, efforts were made to minimize overfishing, but to little effect as more and more boats, with better and better technology, and the relentless pursuit of short-term profit by factory fishing trawlers grabbed the cod from the banks. Just as predictably, fishermen and business interests fought conservation efforts; in denial that they were harvesting away their own futures.
You may ask, TK, “What do the fish off the coast of Newfoundland have to do with internalization?” Well, if everybody takes as much as they want from a finite pool of resources, the pool will run dry. This, is the tragedy of the commons; a shared-resource system whereby individual users acting independently according to their own self-interest behave contrary to the common good of all users by depleting or spoiling that resource through their collective, but individually motivated, actions.
In this allegory, the price discovery process itself is the shared resource. The quotations, prices, history and all of the information content that become the mechanism for properly Pricing Risk in equities are the common good. This underpins capital formation for the private sector and the millions of jobs that depend on its proper functioning.
The consequence of market failure, drying up the price discovery process in this case, is the failing of our own marketplace and its ability as an engine of job creation for investors and issuers.
Karl Marx once said, “Capitalists will sell us the rope we will hang them with”.[1]
Fortunately for our stock market rather than the rope market, this level of greed is kept in check. The operation of the marketplace commons is regulated independently of its participants. Regulators protect the commons itself from our own greed and our own fears.
Likewise, while those who manage client order flow have a fiduciary responsibility to clients for best execution, the recognition of their impact on the commons is their subjection to the fundamental principle that we also have obligations in the Marketplace. For example, “the CSA noted that OPR was intended to instil confidence on the part of all types of investors so that they would contribute to price discovery by posting visible limit orders…”[2] Other UMIR rules on manipulative and deceptive trading practices, just and equitable principles, order exposure and price improvement on dark markets are also based on this Duty to the Marketplace; the duty to the Commons. Perhaps, this Duty needs to be more explicit and enshrined in rules, but nonetheless it is there.
Introduction
Good morning ladies and gentlemen, thank you for giving Independent Trading Group the opportunity to speak about a matter at the heart of our community and what we do – the price discovery process. The price discovery process, which is critical to valuing a firm, adjusting the cost of capital and transferring risk across its participants in capital formation is under threat by the Potential for diminishment of order handling procedures, the flagrant self-interested promotion of segmentation and fragmentation, and application of technology and market structure for the express purpose of avoiding the broader market’s price discovery process rather than contribute to it. For over a year, ITG84 has been trying to bring attention to this matter of grave importance on the potential negative consequences of the direction of our marketplace. The beating of the drums for U.S. style wholesaling have gone too far.
This is not a Bay Street issue around “carving up” P&L, competing for bonus or revenue; not an issue for technologists coding a black box; or for market structure experts opining on the merits of the latest statistics and microseconds shaved off the latest fiber technology. This is an issue that affects investors, corporate issuers and entrepreneurs from Fort McMurray to St John, from Victoria to Chicoutimi. It is an issue for all Canadians, as all Canadians own the marketplace. And I am delighted that Kevin Sampson and the TSX, as Canada’s leading marketplace operator are taking an industry lead in initiating the dialogue. (Congratulations on your promotion by the way!) After this, I hope we open it up as all Canadians “own” price discovery as well.
This is the most important conversation I have had with you on any matters of market structure in over 20 years in the business. So, to that end, my remarks are going to begin do our best to try and speak very plainly, free of jargon, and emotion, about the case we are concerned with and why? I say begin because this discussion must include the interests of end retail investors and institutions. We will also share with you a secret with you, a secret that is obvious and has been hiding in plain sight.
As a housekeeping matter, these remarks and our prescriptions for a more competitive marketplace will be available shortly on www.ITG84.com. Feel free to disseminate our views.
Firstly, let me rebut some opposing positions.
Rebuttal
I only mention this item next because I have heard the comment a number of times and dispelling this myth truly demonstrates how important this matter is to us. “They must be complaining because they’re struggling.” Nothing could be further from the truth. Our view has nothing to do with ITG84’s marketplace position. Indeed, over the past year, since recapitalization, our firm has turned around and grown from the bottom of the league tables; we routinely rank in the top 10 in markets we choose to trade in and compete with the largest firms in the trades we choose to participate in; and are active with volumes that have grown from slightly over 1 million shares a day to over 20 million shares a day. Quite profitable, it would actually be in our economic incentive to keep things as they are, in the direction they are going. Put simply, it hurts our pocket book in the short term to attempt to correct the market issues we have identified. Yet, it is the long-term we concern ourselves with.
I can also assure you this debate is not about big bank vs. small firm. There are many large dealers owned by banks that you will hear from who believe in and actively support the primacy of the price discovery process. There are participants at small firms who believe that they have a “right” to their clients order flow, as they would say they worked hard for it. It is not about retail vs. professional orders. This is about how all orders interact with each other in the marketplace; in particular how valuable information that is contained in quotations is taken for a free ride.
This debate is not about the upstairs market; or client facilitation. These processes transfer real risks between clients and dealers and information content is passed on to the marketplace. Or even the endless debate of how many angels fit on the end of a pin, that the broker-preferencing model presents. To some degree, even broker-preferencing when conducted on protected, competitive markets contributes to price discovery.
This is about the use of technicalities and technology in order to save costs, while free riding the quote without risk. Reward without risk. Participation without contribution … benefiting from the community without even showing up.
Some will say wholesaling works in the U.S. market, and they need it to compete with the Americans. I will be up front and say that perhaps for our most liquid 50/60 interlisted securities, we could carve-out some exemptions that recognize a US competitive context. But we also must recognize a Canadian context and Canada’s needs. Thousands upon thousands of securities on the TSX, TSXV and the CSE trade without the liquidity necessary to provide continuous price discovery. Apple, one security, trades $4.5 billion dollars daily, more than all of the non-interlisted securities in Canada combined, at a penny or less spread.
Wholesaling in this American context is intended to solve for immediacy, as even the race conditions from broker receipt to entry to the marketplace are material to clients. Price discovery is not the problem those securities are solving for – throughput capacity is. While we may choose to flatter ourselves by comparing our needs to the Americans, for the vast majority of our Canadian securities, price discovery is paramount.
Furthermore, our price discovery process must work in bear markets as well as bull markets. While we have had corrections, and the one-year Great Recession, we have not had a protracted bear market in quite some time; so long many in this room have not experienced one. The needs of capital formation, liquidity and price discovery have to recognize that in bear markets volumes decline dramatically as investor interest wanes, and negative, reflexive feedback loops in markets that are thin can and will exacerbate losses and greater economic pain, the market does not properly signal risk.
Indeed, it was declining volumes in an up market that first caused us concern around a year ago. We started to notice things that don’t entirely make sense. The Canadian Equity Marketplace I left behind in 2008 seemed much less attractive in 2017. I don’t want to distract you with too many statistics but a few key points have to be pointed out to back this up. 2017 saw year-over-year declines in total senior market volumes (by some measures 15-20%) at the peaks of a long bull market, with depressed volatility. Senior market share vs. the Americans dipping below 50%.
Most importantly, there are fewer corporate listings on the TSX senior market – 834 vs. 1326 10 years ago. (source – Jonathan Sylvestre TMX Group). The addressable liquidity per corporate listing is down, as the bulk of ADV growth from 383MM shares to 618MM has gone to the 400 net new structured products. Meanwhile real GDP has grown by 16.25% from CAD$1.6T to 1.86T in local currency terms. By any measure in a healthy market we ought 2X as many listings as we have now (note that junior listings are also down by 18% in the period). After such a good bull run, the result is – addressable liquidity per corporate security – down, our Interlisted share – down and this lack of liquidity is affecting our ability to form capital such that we have half the marketplace we ought to? After ten long years, the big picture facts are there. If we continue at this pace in another 15 years there won’t be much left of a stock market to participate in.
Somewhere during this period last winter I started to read Doug Clark’s research. And we met for a wonderful lunch; on Valentine’s Day no less, to start trading observations. As the months wore on the situation appeared more concerning. In June, Independent Trading Group, invited all of the Heads of the Marketplace operators to a roundtable meeting to discuss our observations. To my very pleasant surprise, they all agreed. Every single one!
The intention of this discussion was to discuss some of the challenges faced by Canadian equity markets. We were recognizing that Canada was losing its relative attractiveness, its increasing complexity and opportunity was being lost. Capital formation was being weakened.
Just after Labor Day we met at the gracious hosting by Sean Debotte at Omega’s offices. Doug also joined us. The majority of the CEOs at this roundtable agreed that Canada could do better in terms of market share, addressable liquidity and capital formation. The complexity of our marketplace, and our positioning to Americans was of deep concern. They understood that if not properly positioned, we all lose. Most also understood the need to act and frameworks to do so were discussed.
So, it has been six months since, ITG84, hosted its own roundtable w/ the views of these leaders on matters of capital formation and price discovery.
But, the power of self-interest ruined the day, and to my Deep disappointment a couple of participants could really care less about carrying on discussions further. This power of this self-interest Arguably goes back further with the proposed FOX, FOX2, ATX, and the original Alpha ATS models.[3] The desire to create one’s own sandbox to the exclusion of others has been as timeless as the marketplace itself.
Potential segmentors would tell us that they have good reason to create their sandbox, “to avoid toxic order flow” and “unnecessary intermediation”? Nonsense. This debate is not about predatory trading and the avoidance of toxic order flow. Like a cliché comic book character in a Marvel comic book movie reimagining; the act of demonizing that favorite, yet amorphously defined villain, the HFT, becomes the convenient scapegoat for all ills in the marketplace; and the “go to crisis” to setup the superhero product to save the day!
On close examination, proprietary internalization or client matching systems, which segment flow away from the broader marketplace, exhibits all of the same characteristics of HFTs – latency sensitivity, the use of bleeding edge technologies, algorithms and deep data, with one key distinction. By convincing us that segmentation added value – proponents avoided HFT, then they avoided competitors – will they eventually they will start to avoid trading with you?
And that’s what this debate is about. How do we maintain the proper incentives to keep on trading with each other? Do we continue to go down this current path? Do we allow the potential use or introduction of market operators’ features to avoid the actual marketplace itself? Who decides which intermediation is necessary or unnecessary? Where trades may be done without risk?
If we do continue, over time, eventually, when the segmentors and internalizers need to offset their own risk, you won’t be there for them either. Alarmist you say … no … even in my own career, Montreal, Vancouver, Calgary, San Francisco, Boston, Chicago have all lost their equity trading marketplaces. It is not sacrosanct that ours shall last forever. It must be defended. My earlier point on corporate Issuers should be fair warning enough … ask yourself, at this trend with 300-400 corporate listings – in 10-15 years, will there be much resistance to moving the actual servers that run our Toronto “Structured” Exchange to NYC or Chicago? Who will serve the interests of corporate Canada?
Perspective
Now let me share our perspectives as we build our case. We believe in Canada first. We are Canadians who built a Canadian firm with Canadian money providing price discovery on a Canadian marketplace for Canadian issuers. We recognize global competition, and do so everyday with Interlisted venues and competitors from America. We welcome free and fair competition with Americans. Yet, we do not believe, and are pretty sure Canadians, and their representatives in government do not believe, that non-Canadian jurisdictions would provide the framework for a fair and functioning capital market for Canada’s economy. This is an obvious bias, but in age of rising protectionism amongst our trading partners one that must be articulated up Front.
We believe in the Toronto Stock Exchange. We were born from the TSX as a firm, and in our individual careers, and have been making markets in it for it for over 20 years. We do so in over 140 names including some of the largest issuers in Canada. ATS’ and all participants wouldn’t be as successful without the TSX. ITG84 does not believe it is constructive for participants to try to weaken it, create their own sandbox where they can substitute it and play by their own rules, or bury it.
Finally, we are a principal trading firm. Yes, this means we trade our capital, and we have a book to talk. It also means we have a stake. It means we made a choice to be entrepreneurs. To actively contribute and participate in the market. We can only capture value if we create it in the first place. The key point being is that we had the opportunity, and everyone else should have the opportunity to make that choice. We have a right and an obligation to defend that opportunity.
Hence, the central core of our case, the commons of price discovery, which I described at the prologue, creates the discovery of opportunity, needs to be continuously defended.
This is an industry of opportunity. An industry that certainly fulfilled my childhood dreams having started in the copy room of Burns Fry 25 years ago. This was a business where with hard work; determination, tenacity and an appetite for risk the desire to be self-made could be achieved. An entrepreneurial business, where the leaders stood in between the risks of the needs of business and capital. And I know that for most of you in this audience it has also been rewarding. But for this community called Canada, are we truly providing opportunity where we serve half the corporate issuers we should be?
I truly fear that this possible next twist in our Market – the promotion of synthetic wholesaling, or any relaxation of order handling rules in response to “action on the ground”, is a harbinger of opportunity lost that belies the entire system.
When an order is not efficiently exposed to a protected market there are two obvious immediate and a third longer-term consequences.
- When orders are not exposed both the active order loses the opportunity to have been exposed to a potentially better price at the marketplace and the passive order has lost the opportunity to interact with it. They lose the benefit of being competed for.
- Where the passive order has been riskless matched by an internal system leveraging the NBBO on one side, they are not offering the active client order any direct advantage.
- Most importing this free riding off the price discovery mechanism, over time, erodes its value.
The logical consequence of allowing unprotected minor marketplaces, or unitary market venues, to be at the top of a large dealers routing table is not to force interaction on it, but rather to encourage other large dealers to overfish on price discovery. To create their own ATS’. If I were running product development at an exchange, it wouldn’t be long before I was forced to offer each major dealer such a system. An oligopolistic stasis would evolve. The threats of fragmentation would be complete.
I will put it even more simplistically – is it right to invest more money to prevent orders to get to the auction. What is left of the auction? How do new companies get funded in that environment? Who has leverage over them? Do we want a market where prices are dictated to us? Or we have an equal opportunity to form them?
If we continue to manage, shift, shape, structure, then twist, and torture risk until ultimately avoiding any economic specific risk to the point where we eliminate the incentives to transfer it through a free, fair and transparent price discovery process, no one will take it; the economy will be harmed and these Opportunities to fulfill our dreams will be lost.
We do not believe it is a co-incidence that where there is a spark of life in our equity markets, it is in the CSE, the least segmented of all the listings venues. The least segmented for now. It is also not a co-incidence that the mania over crypto-securities is at least partly driven by the perceived control intermediaries are exerting over the capital formation process. Distributed peer-to-peer assets are another form of pushback by large segments of society that are tired of intermediaries getting more than their fair share.
Spirit of the rules vs. the letter of the rule
On this note, well what do we do? Technology is moving so fast, how do the regulations keep up?
Well, fortunately we have a principles based regulatory environment. Those principles DO NOT need to change to keep up with the permutations of applications that technology allows for. The specific policies supporting those principles simply need to catch up to the advances of technology.
In that other great Canadian game, Hockey, all followers recognized that not only are the players bigger, but also the technology used to play the game is more advanced. The ballistic nylon used in equipment has other uses in advanced space and military applications. The game at one point was evolving away from the spirit with which we enjoy it, the speed, and the finesse was at risk of being overwhelmed by danger to the players. The rule makers did not say to themselves, let’s use this technology to create a different more brutal game because the technology enables that. Ultimately the leaders in the game had the courage to adjust the rules to bring it back to the spirit with which it was created.
So, it will be with great courage that the Regulators will have to remain steadfast to the timeless principles of the spirit of fairness in our auction markets that have served us well through Bull and Bear markets, and introduce policies to keep the potential for abuses of technology in check.
We propose ten practical, simple to implement and upon review, fair and balanced proposals in our one page white paper that will be available on www.itg84com. From this morning we also see other fair and balanced proposals, which frankly may be more effective. We ought to take them all seriously.
For example, systems that internalize should be tested and logs of those tests kept; demonstrating that the systems behave under the various market and technical conditions of order handling rules. This would allow the regulators to understand fully that immediacy was offered to the client, price improvement delivered; and most importantly all actors in the market could take the comfort that all other actors were treating the commons fairly. Unexplained non-random results in unintentional cross rates – up or down could be audited with ease.
In another we suggest that routing tables for the management of retail order flow be publicly disclosed. In this manner, retail trading desks could better compete on the informational basis that they are treating their clients fairly. When most of us learned of the 2.5% protected marketplace rule we did not think that sponsors of these venues would be so brazen as to put an unprotected market at the top of their table. How can a market that is expected to NOT get a first look from the 97.5% of the rest of the market’s price discovery process, the best place for clients to receive price discovery.
Disclosure of conflicts of interest in marketplace sponsorships works.
Conclusion
With great power comes great responsibility. The mantle of leadership of a large business is not just to think about quarter-by-quarter profits. But to think about the generations down the road. In a further cautionary tale, there is one more corollary to the Tragedy of the commons. I call this the irony of the tragedy. It was the very biggest investors who built the largest plants and had the biggest boats to process the most fish who in the very end lost the most capital, as their investments in the eco-system were lost. If I were to have sat in a town hall back in the
1950s, I would say to the Captain of Mr. Big Trawler – you are destroying your own home, your own community. It is not too late to reverse course.
It is one of the more regrettable tales in Canadian history, that the greatest example economists use for the tragedy is a Canadian experience. But it is not with a dire warning that we want to end with, but rather from a perspective of positivity that comes from understanding an open secret. The secret is for the first time in human history we have the ability to see above the horizon. Historically, humanity could only see approximately seven miles. No further than their eyesight. Now we have the ability to see physically and with data the whole world. We can even see into the future. And I firmly believe because of this dialogue that has begun, the data that will be shared, and ideas that will be shared, we will come to the right conclusion. All that remains, is willingness to act.
The opportunity to serve Individuals’ and entrepreneurs’ participation in the stock market must be earned. And earning that opportunity begins by demonstrating to them that we respect their commons in the first place. To the benefit of us all, our children and our children’s children.
My ask of you, is to appreciate that all players have the ability to effect change. Have a voice. Start a dialogue. It is the multiplicity of voices that make a market. Come to our website www.itg84.com and download our prescriptions for a vibrant market. Agree or disagree with us! Sell us short. Make your own recommendations, make a Market and Act independently. The people in this room are the people that can make this happen.
So on that note as I sincerely thank you for listening to the beginning of what I hope will be a fruitful dialogue that will include retail and corporates. I thank you for that most valuable of equities, your time. And I leave you with one final request to follow that final and most quintessential of Canadian values Please Stand on Guard.
Tk
[1] Variations of this sentence are typically attributed to Lenin or Marx.
[2] Paraphrased for speech – exact quote can be found in CSA Notice and Request for Comment Proposed Amendments to National Instrument 23-101 Trading Rules, May 15, 2014.
[3] Fortunately for Canada, these products did not generate material adoption, and historically speaking, they did not result in negative consequences to our marketplace.
DISCLAIMER
These speaker’s notes from the Industry Roundtable on Internalization in Canada’s Equity Markets (Hosted by the TMX January 31, 2018) have been furnished for your information only, are current only as of the date of publication and may be superseded by more current information. These speaker’s notes may not be identical to the comments made during the Roundtable on January 31, 2018. Except as required by law, we do not undertake any obligation to update the information in these speaker’s notes, whether as a result of new information, future events or otherwise.
