Independent Trading Group (ITG) Inc. (“ITG84”) thanks you for this opportunity to
comment on the proposed amendments to TSX’ Market Making Program. Our specific
comments to the issues posed are attached below. We also take this opportunity to
briefly outline our core positions summarized as follows:
Executive Summary
ITG84 supports TSX’ efforts to reform its Market Making Program and welcomes the
entrance of new participants in the Market Making Program via Secondary assignments,
which ought to modernize practices, introduce new technology and greater capital
participation with stronger risk management. The intentions are well meaning and
sound as the additional commitment of less transitory capital at the quote ought to
thicken liquidity at the quote and provide for more meaningful price discovery.
On a practical implementation level we highlight modest concerns and potential
solutions in detail to ensure that:
– Limited resources that provide benefits to Primary and Secondary Market
Makers are not spread too thinly
– New risks that are not well understood are not introduced. Specifically we need
to ensure that the complexity of the program necessitated by a 2-year overlap
period; and emergence of similar programs at other market venues do not drive
gaming behavior by more sophisticated participants.
– And the commitment of All participants is oriented to the longer term
Otherwise a well-intentioned system may fail on practical implementation and lead the
TSX to re-introduce yet another set of reforms to address new weaknesses under
industry fatigue in the future. Our key recommendations to manage for implementation
of this strategy are summarized as follows:
1. The need to preserve the liquidity of the Primary market maker through maintaining
current incentives. This ensures that when the program is launched that there is no
Reduction in liquidity provided by the Primary Market Maker as the Secondary is
introduced. That is that the Secondary Market Makers’ liquidity needs to augment,
not substitute, the Primary’s.
2. Manage the Market Making allocation, and incentive development process via a
segment-by-segment approach. For example, the needs of a Tier B Preferred
security are very different from managing the risk of Tier B Split shares or Multi-class
shares. As well, the less attractive segments of the marketplace to trade should be
reformed in unison with most attractive trading segments. For example, ETFs In
recent years the most attractive segment of the marketplace have been excluded.
We request: a) a moratorium on dealers who managing ETF assignments from
participating in Bidding on Secondary assignments or b) ETFs be open to
competition as well.
3. We believe the Initial allocation procedure upon launch is critical. The TSX ought to
balance and rebalance assignment allocation strategically in a round robin format
to manage an orderly process and reduce the high probability of negative
unintended consequences for its Initial allocation of Secondary assignments.
4. We recommend a simple scoring metric being to: require a certain size at a predetermined
spread a certain % of the time between 930 and before the MOC.
Therefore the size criteria and spread maintenance are binary and a simple singular
% score can be measured. A back-test of proposed metrics would demonstrate how
the scores would have led to security reassignments.
5. Managing the rollout calendar with greater transparency and guidance on
timelines. This change should be no differently managed than a trading engine
release with full transparency on release dates from a regulatory and technology
management perspective. Specifically. Technology resources and development
work will have to be done on the Market Makers’ end to match the code behaviour
of an automated system to the proposed performance metrics. The marketplace is
not served if bidders are bidding without having built software their software to
demonstrate adaptability to the new model. It is not reasonable to expect a build to
be finished until these reforms are actually approved. Therefore a reasonable lead
time for coding, and testing should be considered before Secondary assignments are
made, and this timeline should be backed with a TSX commitment to encourage the
investment necessary from its Market Makers.
Response to Request for Comments
Our specific feedback is as follows:
1. Changes to allow more than one Market Maker to be assigned a security
Introduction of Secondary Market Maker & the Strategic Value of Market Making to an
Exchange
The values of a Market Maker to the marketplace as a whole are well versed. The
marketplace as a whole benefits from continuous permanent liquidity provision,
prevention of gapping and the filling of normal course orders. This ensures a fair and
orderly market to the common participant seeking to buy and sell securities on an
Exchange. But providing these benefits does not come without risk as permanent
liquidity provision leaves a Market Maker with the significant risk of writing put and call
options on the price of convenience for Marketable orders. Compensating for this risk,
market venues confer pricing or informational advantages to Market Makers. The form
of these advantages is more important to market quality and the performance and
profitability of the Market Maker than is the substantive level of those advantages. This
trade-off has generally been the crux of the debate on Market Making programs.
As well, a Market Maker also has strategic value to a specific Exchange. That is, these
compensating incentives, and commensurate scoring mechanisms to ensure that
Market Makers fulfill their obligations also have the commensurate characteristic of
driving behavior that can benefit a particular Exchange overall and not only the trading
of a security on this Exchange. What behavior is TSX trying to motivate? Rather than be
circumspect, we believe it is acceptable for the TSX to deliberately try to motivate both
the increased Velocity of trading (defined as average daily volume traded / free float)
and market share (vs. the United States & Domestically) and attraction of new
participants to Canada. These three goals in combination grow the overall marketplace
opportunity for participants and consequently market quality through enhanced order
flow for liquidity to trade with. These are also worthy and attainable goals that
demonstrate value to all participants and Issuers alike, also increasing the value of the
Exchanges’ market data and listings. We suggest the following plan be addressed to
enhance the strategic value of the program:
Ø Approach the Market Making allocation, and incentive development process via
a segment-by-segment approach. Specifically, it is obviated in the Tier A / Tier B
methodology that the needs of Market Makers and those who seek their
liquidity are radically different. Tier B liquidity is essentially subsidized by the
benefits presented in the Tier A opportunities. Yet we also want to highlight that
the needs within Tier B are also unique. For example the needs of a Preferred
security are very different from managing the risk of Split shares or Multi-class
shares. We highlight a number of different segments across Tier B (Appendix),
which could benefit from specific incentives. If all reformed in unison this would
present too much complexity, but various individual segments could be
approached with targeted incentive models to capture market share and
enhance overall market quality. Less attractive segments could be better
managed if not fragmented but rather consolidated as packages for those
building custom systems to manage their risk. At a minimum this should be
considered in the Allocation system.
Ø While the marketplace will argue that it is sensitive to introducing too many
changes and complexity at one time, and while this is a valid point the less
attractive segments of the marketplace to trade should be reformed in unison
with most attractive trading segments.
o We specifically note that ETFs have been excluded from the Reform
process. In recent years this has been the most attractive segment of the
marketplace to trade.
o ETF Market Makers are pre-dominantly bank-owned and receive these
assignments through Issuer endorsement. We find it unfair that single
securities, which are predominantly managed by Independent dealers,
will be opened to competition (likely from bank owned dealers) without
issuer endorsement, while bank-owned dealers will not have competition
in their most lucrative segment and can continue to monopolize via issuer
endorsement. Bank-owned dealers will use the profitability and scale
from their ETF Market Making to leverage gains in their Secondary
Market Making, while Independent dealers will not have this reciprocal
opportunity to develop scale on an equal opportunity basis.
o In order to specifically manage for this potential systematic bias and
unfairness, we request: a) a moratorium on dealers who managing ETF
assignments from participating in Bidding on Secondary assignments or
b) ETFs be open to competition as well. More specifically, ITG84 would
be delighted to bid on a number of secondary assignments for ETFs along
with a wide swath of Tier B assignments.
Reciprocating Partnership – Incentives to Market Makers for Providing this Strategic
Value
At first blush the reaction of the community would be that the “value” to the primary
Market Maker is diluted by the introduction of a secondary that shares in the pool of
benefits including Rebates and Participation rights.
The Primary Market Makers rebate benefits should be maintained at their current level,
and be higher than that offered to the Secondary. This ensures that when the program
is launched that there is no Reduction in liquidity provided by the Primary Market
Maker as the Secondary is introduced. That is that the Secondary Market Makers’
liquidity needs to augment, not substitute, the Primary’s.
Over time, as the Primary assignments open up to Secondary participants, Secondary
participants (including ITG) who are better will have the opportunity to benefit from
becoming the Primary. In the meantime, it is critical to ensure that the Secondary is
adding liquidity that is not cannibalistic to the Primary, which would render the program
Moot. Secondary Market Makers ought to be successful in augmenting liquidity not
solely relying on rebates.
To the extent that Rebate differentials for the Primary remain unaltered, and
participation rights are automated via the proposed MGF facility automation changes;
the dilution of participation opportunity from introduction of a Secondary could be
offset if the TSX is actually able to increase flows that are initially directed to its
marketplace.
We are optimistic, as current MGF levels are at the lower end of the permissible range.
Automation should allow MGF levels to rise, and the increase of the MGF presented to
the marketplace with a secondary, should add to the addressable liquidity that is
executed by the TSX.
But the marketplace needs to consequently see an increase in market share, average
size of orders coming to the book, and the frequency of retail participating in TSX at a
higher level, for both the Primary and Secondary Market Makers to find that this
proposal is beneficial in the longer run. TSX needs to deliver on: automation, a healthy
rebate model, and a fair and robustly considered initial allocation model.
We highlight the incentives that ought to be introduced or maintained in order to
provide macro-business model incentives (as opposed to the trade – level incentives).
Specifically:
• Market Making participants should have the right to sell their Primary
assignments (via auction) in order to incent investments. More specifically,
while the current proposal continues to allow dealer-sponsored assignments on
primary names; it is not clear whether the continued model for transferring
assignments upon trade desk moves, corporate events, or changes of control will
continue to allow Primaries to consider their assignment lists as “intangible
assets”. This intangible value creation promotes a willingness to invest.
Ø We are not opposed on Secondary assignments being awarded on a competitive
basis, but not all relinquishments should be treated this way. For example a
desk may do an admirable job, but a dealer-member may seek to “sell” that
business. The desk should continue to be allowed to do that business without
being forced to relinquish.
Ø Providing macro level incentives. For example market data rebates. Market
Makers are expected to submit quotes, provide the very liquidity that makes
these quotes valuable and yet are necessitated through the automated nature of
the program to consume more expensive direct feeds and co-location facilities.
Recognition that Market Makers contribute inputs to the value of these products
through a mechanism to reduced fixed communications costs would be
welcome.
Ø Lower cost hedges ought to be introduced. For example, if the Exchange were to
award securities based on various segments (for example energy) and it were to
provide mechanisms to hedge (via its MX unit) through specific reductions in
Options trading costs; overall rebate levels could be lower to the Exchange, but
risk management enhanced for Market Makers, translating into better Quotes in
both Cash and Derivatives markets.
Ø There should be no prohibition on a Market Maker trading as a Market Maker on
other marketplaces
Specifically Requested Comments on Proposed Changes
2. Changes to the Minimum Guaranteed Fill (MGF) Facility
We applaud and welcome changes to the MGF facility that will allow our systems to
adjust MGF values intraday. Specifically the ability to change MGF values, coupled with
Participation on/off per side via FIX message. This will allow Market Makers to a) shape
their risk profile in a more systemic way; b) introduce anti-gaming logic to those that
abuse the MGF and c) dynamically compete between the Primary and Secondary Market
Maker.
We agree some reasonable limitation on the # of changes allowed each day will
continue to provide transparency to the marketplace.
It is imperative that the new automated capability is introduced contemporaneously
with the competitive model.
We do question how TSX intends to maintain consistency across min. MGF between the
two Market Makers. Specifically, while Market Makers will be subject to the same
minimum and maximum sizes; there is an opportunity for one Market Maker to “free
ride” off the capabilities of the other by effectively matching the more sophisticated
participation and MGF parameters without developing the software to go into the
decision making process.
3. Clarification to the odd lot policy regarding improper use of the odd lot facility
ITG supports the Proposed Amendments which clarify that entering multiple odd lot
orders on a specific security from multiple managed or discretionary accounts in
connection with a single investment decision will also constitute an improper use of the
odd lot facility.
4. Re-organizing the Market Making rule and policy framework
We caution TSX on what appears to be a very complex and automatic methodology for
both who gets assignments and how you meet your obligations. The more complex the
program, the more it opens itself to be gamed. And the more it can be gamed, the
more it favors the participant who is willing to learn the rules of the game. Our
comments on the changes to the rule and policy framework revolve around two broad
areas – allocations and scoring.
a) Allocations
The formula for choosing Secondary Market Makers is particularly complex. We believe
these formulas should be easily to explain and understand to motivate the right
behavior amongst traders, Issuer and retail Investors.
Most importantly we believe the Initial allocation procedure upon launch is critical. The
TSX ought to balance and rebalance assignment allocation strategically in a round robin
format to manage an orderly process and reduce the high probability of negative
unintended consequences:
• The riskiest outcome of a “big bang” approach to allocating Secondary
assignments is gaming in the bidding process in a manner which crowds out
serious, experienced bidders from those that “market” themselves to the
Exchange. A formulaic approach incentivizes bidders to provide the best
possible, yet potentially unachievable bid, in order to garner as many
assignments as possible in order to “crowd out” other participants. Put simply,
the best bids are not always the most sustainable; but if core competitors have
been excluded from the marketplace by trying to be reasonable and fair in their
bids, they will have already been excluded and would be unwilling to participate
in future allocations.
• As well, it needs to be very transparent that the quality of bids on Tier A
securities are tied to the quality of bids on Tier B’s. For example at its most
extreme, we question how allocations would occur if a bidder was the “best” on
all their Tier A bids, but second on their Tier B bids? What would happen in the
converse situation? Likewise if a firm bids for more Tier B’s relative to A’s, but is
second in more of its Tier A bids, should it not follow that it should receive an
outsized share of these responsibilities as it is willing to step up? It is highly
improbable that the best bid approach will result in a neat and tidy allocation of
A’s and B’s spread across a # of participants.
• A formulaic approach also does not recognize that over the longer-term Market
Making firms develop expertise in the various segments mentioned above. For
example, our own firms’ expertise in Materials, Financials and Preferred
securities. The TSX should maintain discretion to allocate according to this
expertise.
We suggest a multiple round robin of bidding whereby all initial bids are reduced to 3
bids per security in a closed auction environment. Then each bidder should receive
each other bid characteristic they are competing with and be allowed to bid on a second
round only if they are bidding on a commensurate quantity of Tier B assignments. They
should then be narrowed down to the two best participants, and bidders allocated
securities across the basket of securities where they are between the two best.
Winning bids for both Primary and Secondary assignments should always be disclosed
such that losers in the bidding know how far off they missed, and what it would take to
match in future allocations.
We also recommend participation from the Market Making community on a Market
Making allocation committee in order to ensure transparency and fairness in a cooperative
and collaborative manner.
As well, we question whether a concentration limit of more than 20% is appropriate.
This 20% limit was designed when the TSX had only 1500 securities. With a larger
security base a lower concentration limit would still allow Market Makers to achieve a
critical mass with 400 names.
Finally, we suggest that non-voluntary assignments should not be equally allocated
amongst firms on a rotational basis. Instead it seems like they should be proportionally
allocated. If an MM has 20% of the voluntary assignments they should get 20% of the
involuntary assignments.
b) Scoring Mechanism
We believe that performance measurement incentivizes behavior. Put simply, what
gets measured gets managed. If the behavior that TSX is looking for is the highest
market quality, an easy to understand definition of market quality is easier to manage.
More complex models open themselves up to “gaming”. Other marketplaces have
similar programs with easy to understand metrics.
For example we recommend a simple scoring metric being to: require a certain size (our
bid in the allocation process) at a pre-determined spread a certain % of the time
between 930 and before the MOC. Therefore the size criteria and spread maintenance
are binary and a simple singular % score can be measured. A simple, easy to understand
a communicate measure which most importantly achieves the Exchange’s goals.
Notwithstanding, we have specific feedback as follows:
Ø Spread goal – how does TSX know the proposed goal is correct and not too wide
or narrow of ATWS? Bids that are too narrow can be just as harmful to the
program as bids that are too wide are to market quality. Narrow bids discourage
“fair play” from participants as they are crowded out (see above). The existing
scoring mechanism is self-correcting; while the process to ensure that changes in
spread goals are fair is not clear.
The following measurement also needs to be managed out of the scoring: “A
trade is considered to be within the Spread Goal if the difference in its trade
price from the previous trade price is equal to or less than the Spread Goal”. The
previous trade could have happened 5 hours before and the entire market could
have moved. There ought to be a mechanism for dropping stale data from the
scoring mechanism.
Ø % Time NBBO, double counts the MGF (i.e. a Market Maker will always be at the
best bid/offer with MGF). Measuring this effectively requires a Market Maker to
display quotes at the NBBO for non-MGF eligible orders, increasing its liability to
the marketplace. On the one hand TSX claims it seeks to promote market
quality, but this metric is intended to ensure Market Maker quotes are
embedded in routing process, in order to attract orders to TSX. Put simply,
market share.
Ø If this is the case – Market Makers should be rewarded with achieving Market
Share metrics, which supersede theoretical goals. If a Market Maker has helped
maintain market share through the % of time at NBBO, it wouldn’t be fair to lose
a stock based on metrics that don’t reflect actual results (if TSX has 100% share
in a name, its market quality is by definition better than that of all of the
alternatives).
Ø Top of book size, includes many metrics that are not in the Market Makers’
control including, size not attributable to the Market Maker – i.e. all size at the
top of book at the TSX, the MGF size.
Ø The TSX has all the data necessary to provide back tested performance scores to
provide proper analysis of how the above scores are fair. TSX ought to present
the marketplace and the regulators back-tested performance data to show how
the new score would have demonstrated where market quality would be
enhanced. As well a back-test would demonstrate how the scores would have
led to security reassignments.
Ø Penalties for underperformance. We understand monthly credits are only
rewarded for months where performance passes, even in the current
mechanism. It will be imperative that a real-time mechanism to view
performance is available to keep track of performance. We understand this is
planned. The program should not be launched without this. Otherwise, Market
Makers will be at risk without having a view into managing their liability (i.e.
rebates being cancelled)
Ø Maintaining fairness across the Primary and Secondary model. While we
understand that the Primary will have a “shadow” secondary score to assist in
their evolution, we also believe it is imperative in the long run to maintain
fairness between both Participants and the scoring across them. We believe that
the primary and secondary should see each other goals and scores. There is no
better replacement for transparency to generate fairness.
Again, most of this feedback is moot, if we revert to a simple scoring system.
This market structure change should be no differently managed than a trading engine
release with full transparency on release dates from a regulatory and technology
management perspective. Specifically. Technology resources and development work
will have to be done on the Market Makers’ end to match the code behaviour of an
automated system to the proposed performance metrics. The marketplace is not
served if bidders are bidding without having built software their software to
demonstrate adaptability to the new model. It is not reasonable to expect a build to be
finished until these reforms are actually approved. Therefore a reasonable lead time
for coding, and testing should be considered before Secondary assignments are made,
and this time gap should be backed with a firm commitment to encourage the
investment necessary.
Finally, we reiterate that we support the overall strategic goal of TSX to enhance and
enhance its Market Making system through the introduction of more competitive
elements, and modernization. Our key recommendations around: I) the need to
preserve the liquidity of the Primary market maker through maintaining current
incentives ii) the introduction of segmentation and dealing with ETFs; iii) an Initial
allocation method through a round robin system; iv) a simpler scoring mechanism with
back tested results are intended to assist TSX in accomplishing this aim and v) managing
the roll-out calendar with great transparency. Ideally, TSX gathers feedback from
various participants and makes tactical adjustments to achieve an even better outcome.
Thank you for the opportunity to provide our comments on TSX Proposal. Please feel
free to contact us with any questions or requests for clarification.
Sincerely,
Thomas Kalafatis, Chief Executive Officer
Independent Trading Group (ITG) Inc.
370 King Street West, Suite 701
Toronto, Ontario M5V 1J9
tk@ITG84.com
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