The first academic paper to examine the TSX Alpha speed bump, Dr. Sean Foley’s “The Value of a Millisecond: Harnessing Information in Fast, Fragmented Markets” has been published and it comes to a troubling, but not unexpected, conclusion: the TSX Alpha speed bump is detrimental to overall Canadian market quality and has only benefited predatory High Frequency Trading strategies. Reading this paper leads me to offer some key pieces of advice:
- Institutional investors and dealers – do not touch TSX Alpha with a 10-foot pole. When placing an immediately tradable order on TSX Alpha, there is a high likelihood the quotes you think are there to trade, are not. They will fade. When placing a non-immediately tradable limit order on TSX Alpha, there is a high likelihood that, when it trades, you will be lifted by someone who has better information than you and your outcome will be negative.
- Retail investors and dealers – don’t play the game of those who seek to harm the Canadian market. You are regarded as uniformed flow, with predatory High Frequency Traders (HFTs) paying to access your liquidity. As a retail investor or dealer, your quality of execution may feel the same as on other marketplaces, but trading on TSX Alpha fuels a model that enables outright predatory trading, that is detrimental to the Canadian market overall and that negatively impacts investments you or your clients hold with Canada’s largest institutional investors.
- Securities regulators – put an end to the TSX Alpha experiment. The promises were appealing, but now it is demonstrated that TSX Alpha is nothing else but a wholesale market-making platform with payment for order flow, enabling the resurgence of spoofing in our markets. This clearly goes against your intentions and benefits a select few to the detriment of the many.
As I mentioned earlier, this should not come as a surprise.
Not all Speed Bumps Are Created Equal
The TSX re-launched its Alpha marketplace in September 2015, claiming that its speed bump 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.”In addition, upon regulatory approval, the TSX stated that “Alpha's innovative new trading model is designed to deliver superior execution quality for natural investors and reduce trading costs for retail and institutional dealers”.
Their solution? A speed bump that slows down, on a randomized basis between 1 and 3 milliseconds, all orders on TSX Alpha with the exception of Post Only orders. Post Only orders are limit orders that get automatically cancelled by the marketplace if they were to trade upon entry. This order type is typically used by HFTs. The speed bump and order type are coupled with a fee structure where rebates are paid to those who take liquidity and fees are charged to those who supply liquidity.
After the approval by Canadian securities regulators of TSX Alpha’s speed-bump, I raised substantial concerns about that decision, corroborated by many industry experts. I did this because I saw the speed bump being implemented in a perverse manner with misleading claims about how it would benefit natural investors and Canadian markets overall. At NEO, we are supportive of speed bumps that, when applied properly, benefit fairness and liquidity in the markets. We are also supportive of competition as a means to spur innovation. But TSX Alpha is neither of these two things. Instead, the re-launch of TSX Alpha is a solution that benefits one stakeholder group – predatory HFTs – at the expense of all others and the overall health of the Canadian markets.
The Value of A Millisecond
One year since the re-launch of TSX Alpha my fears have been confirmed. Dr. Sean Foley, a finance Professor at the University of Sydney and an expert in stock market integrity and regulation, published the first academic paper to analyze the impact of a speed bump. To truly understand Dr. Foley’s analysis, I encourage you to read his paper in full or watch the presentation he gave at a “NEO Presents” event on October 31, 2016. For those of you who want the Coles Notes, here are some key findings from Dr. Foley’s research:
TSX Alpha’s quote fade1 percentage increased dramatically upon the re-launch of TSX Alpha, while it remained unchanged on the other venues considered in the analysis. In other words, an investor’s ability to access the liquidity displayed on TSX Alpha plummeted.
Diagram 1: Percentage of quotes on TSX Alpha that fade when an investor tries to trade against them
Source: Dr. Foley
This poor persistency of TSX Alpha quotes is further corroborated through research published by ITG Canada in its Q3 2016 Canadian Microstructure Review.
Diagram 2: Percentage of quotes per venue which persist for less than 1 millisecond
Source: ITG Canada
This diagram shows us the percentage of orders per Canadian marketplace that persist for less than 1 millisecond. It stands out that on TSX Alpha (ALP), a whopping 15% of quotes last for less than 1 millisecond2. This becomes very disturbing when we consider that those who may want to access those quotes are slowed by a speed bump of 1 to 3 milliseconds, which makes it physically impossible to access them. Isn’t this spoofing?
Dr. Foley also identified a clear correlation between quote fading on TSX Alpha and trades taking place on other marketplaces. Predatory HFTs on TSX Alpha immediately cancel their Post Only limit orders when they have detected a large (probably institutional) order coming in and trading on other marketplaces, while long-term investors with limit orders on TSX Alpha are left with adverse selection3. In other words, predatory HFTs have been able to leverage the Post Only order type to benefit from access to critical information on likely future price movements occurring within the next milliseconds, while long-term investor orders are held up in the TSX Alpha speed bump.
Diagram 3: Percentage of quotes on TMX Alpha that trade, fade or stay after quotes on TSX, Chi-X & CX2 were cleared out
Source: Dr. Foley
As a result of the quote fading and adverse selection, institutional order flow avoids TSX Alpha while retail order flow, attracted by the rebates financed by predatory HFTs, seeks to lift liquidity when it is available. Isn’t this a wholesale market-making platform with payment for order flow?
Dr. Foley’s research further confirms the characteristics of a wholesale market-making platform with payment for order flow with its finding that HFTs providing "liquidity" to TSX Alpha earn approximately $20 million per year extra, fees deducted.
- Finally, and even more disturbing, Dr. Foley’s transaction cost analysis also found that the re-launch of TSX Alpha with its speed bump increased Canadian market-wide order flow toxicity, reduced market-wide liquidity provider profits and increased overall Canadian transaction costs by $105 million (conservatively) since launch. Who feels the burden of this cost? Institutional investors, including pension funds, mutual funds and other types of asset managers, as well as all the unit holders and other investors they represent.
Doing What is Right for the Canadian Capital Markets
During the 2008 financial crisis, the Canadian financial industry, and its capital markets arm in particular, was a beacon of light in unstable times. That was the result of doing what is right to protect our markets and economy, rather than focusing on short-term profits. TSX Alpha exemplifies the exact opposite of this attitude. To the benefit of all, we ask the TSX to remember its core purpose as a stock exchange and to stop the TSX Alpha experiment. It would be a great way of starting to do what is right for investors, dealers and capital-raising companies in Canada.
1 Quote Fade: Displayed liquidity that disappears when you try to trade with it.
2 It is also worth noting that on the TSX trading platform (TSX), the percentage of quotes that persist for less than 1 millisecond is averaging 10% and more, ranking it at the second Canadian market with the most unreliable quotes.
3 Adverse Selection: when you trade with someone who has better information than you and the outcome for your trade in negative.