NOT ALL SPEED BUMP

MARKETS ARE CREATED EQUAL

UNINTENDED CONSEQUENCES, CONFLICTS OF
INTEREST AND THE CHAOS THAT WILL STEM FROM
A PARTIAL ORDER PROTECTION RULE

AN AEQUITAS NEO EXCHANGE POSITION PAPER

JULY 2015

ORDER PROTECTION RULE (OPR)

OPR was introduced in February, 2011 as a result of changes made by the Canadian Securities
Administrators (CSA) to National Instruments 21-101 Marketplace Operation and 23-101 Trading
Rules. One of the key reasons was to protect retail investors from the complexities of fragmented
markets. The intention was to ensure that retail investors were not disadvantaged by the fact that
they are not as technologically sophisticated as other market participants and to provide comfort
that regardless of where their orders were placed, those orders could not be ignored:
In a multiple marketplace environment, the assurance that better-priced
orders will be filled ahead of inferior-priced orders is essential to maintain
investor confidence and fairness in the market. Order protection is especially
important to ensure the future participation of retail investors that have an
historical expectation of such protection. Without such protection, there may
not be sufficient incentive to contribute to the price discovery process because
investors who disclose their intentions are not assured of the benefit of having
their better-priced orders filled while others are able to use this information
in their trading decisions. In addition, investors, including retail investors,
may lose confidence that their orders are being treated fairly. This in turn,
may contribute to the perception that an unlevel playing field exists providing
certain participants with advantages over others. Such a perception may
ultimately result in the removal of investors from the market.
CSA NOTICE OF AMEMDMENTS TO NI 21-101 and NI 23-101 (2009)

In those four years, the Canadian equity market has evolved and currently looks drastically
different. Given this evolution, is OPR still doing what it was intended to do? Although the original
purpose behind OPR was well-intended and arguably right at that time, we are now operating in an
environment with over ten protected markets dominated by High Frequency Trading (HFT) firms
and other professional intermediaries.

UNINTENDED CONSEQUENCES
In most cases, OPR no longer serves to protect the retail investor. It has instead evolved into a
structural enabler for trading strategies, many of which are predatory, deployed by trading firms that
have the ability to leverage speed to take advantage of information at the microsecond level.
These firms have invested millions to be co-located with marketplaces using the best hardware,
fastest possible network connectivity and access to the best data money can buy, simply to have an
informational advantage over other market participants. OPR has provided a perfect eco-system for
those seeking to carry out predatory trading strategies.
An example of such an OPR-enabled predatory trading strategy would be as follows:
1. Place small orders across multiple marketplaces using the speed advantage to set the National
Best Bid and Offer (NBBO), knowing everyone else will be forced (because of OPR) to trade
with these orders first;
2. Use computer algorithms to identify trades from institutional investors or large retail orders, i.e.
long-term investors (LTIs) that frequently break up orders to reduce market impact;
3. When an LTI order trades with one of these small orders, leverage the speed advantage to receive

the information about this trade before the rest of the market;
4. Use this information, and the knowledge that the LTI order will next try to trade orders on
other marketplaces (because of OPR), to technologically front-run that incoming LTI order, fade
displayed quotes and ultimately trade with the incoming LTI order at a less favourable price to
the investor.
These unintended consequences have been exacerbated due to changes from marketplaces to their
trading fee models, where fees are charged or rebates are paid according to whether the order is
taking liquidity or providing liquidity.
The original make for a rebate/take for a fee fee models were viewed as consistent with the
concept of encouraging investors to post resting orders and contribute to price discovery, and
seemed therefore consistent with the intentions of OPR. However, over time these fee models have
distorted the economics of trading and promote the HFT trading strategies that led to unnecessary
intermediation and unreliable liquidity (e.g. rebate arbitrage).
When marketplaces attempt to attract flow by moving to an inverted fee model (take for a rebate /
make for a fee) there is no alignment with the intentions of OPR quite the contrary. The proponents
of inverted markets typically cite the benefit of being able to pay a small fee to get a better position
in the queue of a marketplace where typically a large number of retail orders are posted, instead
of having to compete with other orders on marketplaces that offer a rebate to post. To understand
the impact of inverted markets it is important to ask the following question: who posts orders on a
marketplace where they have to pay a fee?
It is not the cost sensitive retail dealer. Retail dealers will, however, be takers of liquidity
on inverted fee model marketplaces because they will have the opportunity to receive a
rebate to do so, which they cannot obtain on make/take marketplaces.
It is typically HFTs that are prepared to pay a fee to post orders for the benefit of interacting
with retail flow.
What is the impact on institutional investors?
Institutional investors will be concerned about information leakage and will likely direct
their dealers (or use direct access) to trade elsewhere.
There is nothing wrong with any of this as long as the retail dealer can demonstrate best execution.
However, when we take OPR into consideration, we come to the following conclusions:
It is not retail orders that are being protected on inverted fee model marketplaces but
orders from HFTs and other technologically sophisticated intermediaries, which were not
the intended beneficiaries of OPR protection.
With OPR, all trades are required to go to the marketplace with the best prices first
(regardless of size), this makes inverted fee model marketplaces the perfect place for
predatory traders to post small orders to get the first look at any type of flow and then
deploy the type of strategy discussed above.
Not only has OPR become a mechanism to protect orders from sophisticated players who do not
need protection, but it also facilitates the ability to deploy predatory strategies to the detriment of
the end investor who the regulation was supposed to protect in the first place.

NOT ALL SPEED BUMPS ARE CREATED EQUAL

When the Ontario Securities Commission (OSC) approved the changes to the Alpha Exchange Inc.
(Alpha) model this past April1, they did so with the caveat that it would become an unprotected
market. Approving it as a protected market would clearly have been problematic given the fact that,
on top of everything else that was just discussed about inverted markets, adding a speed bump to
give HFTs even more of an advantage, and institutional and retail investors more of a disadvantage,
would have been unsupportable.
As a result, the CSA followed up the OSCs Alpha approval with a request for comment2 that
poses the question of whether all marketplaces with a speed bump should become unprotected.
Notwithstanding our obvious interest in this issue, we fundamentally believe that this is not the right
question, for reasons explained further down. First, though, let us look at the differences between
the new Alpha and the Aequitas NEO BookTM, especially the impact of the speed bumps on both
exchanges.
DEALER

NEO BookTM
Fee model Take-take (no rebates, both sides pay a

fee)

Alpha3
Inverted (rebate to take, fee to post)

Anticipated Liquidity Market makers (HFT or not), other HFTs

Providers and institutional investors

HFTs only

Anticipated Liquidity
Everyone
Takers

Retail only (for reasons explained below)

Speed bump Applies only to latency sensitive traders

implementation (HFTs) trying to take liquidity (to curb a

potential technology front-running type

of strategy)

Impact of speed bump

on investors Levels the playing field and protects

liquidity providers from predatory HFTs

to the benefit of all liquidity seeking
investors

Applies to all orders except Post Only

orders (typically used by HFTs to get first
in the queue and layer the book)
All investors orders are slowed down
giving HFTs (who are not slowed down)
ample time to adjust their quotes based
on better access to information (this will
further amplify predatory trading)

Institutional and retail investors would

be forced to send their orders to a market
are not prevented from providing reliable
where they are slowed down, whereby:
liquidity (promoted by the matching
Institutional investors orders will
mechanism used), but are prevented from
most likely not get filled as HFTs can
playing out technological front-running
detect and will fade their quotes to
strategies.
avoid interacting with their flow; and

Retail investors will always be taken
The protection of the NEO BookTM also
advantage of when the markets move
impacts HFTs ability to deploy predatory
against them while their order is
strategies on other markets as they cannot
being delayed.
TM
circumvent a protected NEO Book by
This puts best execution at significant risk
simply ignoring those quotes.
for both retail and institutional investors.

Impact of speed bump

if market protected No impact on anyone except HFTs who

1 https://www.osc.gov.on.ca/documents/en/Marketplaces/alpha-exchange_20150421_noa-proposed-changes.pdf
2 http://www.osc.gov.on.ca/documents/en/Securities-Category2/csa_20140612_23-101_rfc-pro-amd-processing-delays.pdf
3 http://www.tsx.com/resource/en/683/reshaping-canadas-equities-trading-landscape-2014-12-10-en.pdf

THE OPR-DRIVEN CONFLICTS OF INTEREST

As discussed above, Alpha will be an unprotected market that pays a rebate to dealers who route
their retail flow through Alpha. However, those retail orders will also be subject to a speed bump
before trading with any available liquidity.
Given this information, consider the following example: if the best price on Alpha is the same as the
best price on the NEO BookTM and there is enough volume on both markets to fill a small retail order
completely (since the price is the same on both markets, the retail broker can choose which market
to send the order), the retail broker then decides to send that order to Alpha because they will be
paid a rebate to do so (the same order would have traded for free on the NEO BookTM). Once that
order is sent to Alpha it will be subject to a speed bump for a few milliseconds, which may not sound
like much but in a modern electronic trading environment that is more than enough time for a lot of
things to happen. In that period of delay, some event may occur (news, activity on another market,
etc.) that causes the liquidity providers to adjust their prices. When that occurs, the retail order then
ends up trading at an inferior price compared to what would have happened if the order was sent to a
market without a speed bump (such as the NEO BookTM). In our minds, this takes existing conflicts
of interest with inverted fee models to a completely new level, where best execution for the
client gets compromised because the dealer is incented by the regulatory structure and pricing
models to choose to send the clients order to a marketplace that imposes a systematic delay on
it, simply because the dealer will receive an economic incentive to do so.
Our opinion is that segmentation of order flow in this way, enabling predatory trading strategies,
is detrimental to best execution for long-term investors and overall market quality. This type of
segmentation results from marketplaces with inverted fee models in general and even more so in the
Alpha model with the speed bump.
We believe it is possible to build a marketplace where all industry stakeholders can co-exist and
flourish. The NEO BookTM was specifically designed to promote and protect liquidity formation to
the benefit of all liquidity seeking investors. We believe in fair access and that all liquidity providers
should be able to compete on equal terms, regardless if they are HFT firms or institutional or retail
investors.
This would no longer be the case if the NEO BookTM were to become an unprotected market, for two
reasons:
1. Institutional investors will be at a competitive disadvantage compared to proprietary HFT firms
who are in complete control of which market they access, and have the ability to quickly post and
cancel their orders on an unprotected displayed marketplace. On the other hand, dealers that
trade on behalf of their clients will be hesitant to post client orders on such markets where they
are not price-protected and could get traded through. This is due to the lack of a well-defined
best execution regime that demonstrably takes into account, monitors and enforces all elements
of execution quality.
2. As discussed in the speed bump comparison above, HFTs ability to deploy predatory strategies
on other markets will no longer be negatively impacted by the protection of the NEO BookTM.

RECOMMENDATION FOR THE REGULATORS

As we previously discussed in our comment paper on the proposed OPR thresholds4 , we continue to
be of the opinion that a bifurcated market with both protected and unprotected markets will do more
harm than good. We are convinced that the added costs, complexity and uncertainty of a bifurcated
market will far outweigh the benefits. We also believe it will be detrimental to best execution for all
types of market participants except for those employing predatory trading strategies.
1

We believe the regulators have a number of options in front of them:

Use Alpha as a pilot project to study the effects of unprotected displayed marketplaces
on market quality. The Alpha model as an unprotected market was unfortunately never
subject to any public comment process and it is clear that the consequences hereof have
not been adequately analyzed. We believe the regulators have grossly underestimated the
ripple effects of this decision and it will lead to chaos in the Canadian markets. This would
be a less risky approach in the short-term.
Remove protection from marketplaces based on whether they have developed mechanisms
(i.e. Alpha speed bump, inverted fee models) that enable predatory trading strategies. This
would not include the NEO BookTM because it seeks to achieve the exact opposite. This is
a potential long-term solution.
Revisit the current regulatory approach and remove the order protection rule altogether.
Regulators can either continue along a mixed path of prescriptive regulation and principlesbased regulation or they can focus on the principles. This would be our recommended
long-term solution.
Prescriptive regulation requires thorough data analysis (which is only helpful where it is clear
which data would be instructive and such data is available) and, if done consistently, means that
each individual marketplace and proposed rule change must be studied on a caseby-case basis.
Taking the example of applying the unprotected status on markets with a speed bump (at the surface,
a similar feature) begs a lot of questions:
Should inverted markets be unprotected based on the rationale for OPR provided above?
Should the long-life order proposed by the TSX, which imposes a systematic delay (speed
bump) on any order operations (i.e. changes or cancels) after one second, lead to the TSX
becoming an unprotected market?
Should marketplaces that have chosen significantly slower technology than the others be
unprotected?
As stated above, we believe that whether marketplaces with a systematic order processing delay
should be protected or not is the wrong question. Furthermore, we believe a debate over what
should be protected and what should not is not in the Canadian securities markets best interests.
The Canadian markets have evolved to a point where it is time to reconsider OPR and move towards
a best-execution-only regime. Let competitive forces determine which marketplaces add value and
which do not, and allow the regulatory bodies to focus on instituting a transparent best-execution
framework that puts the power back in the hands of investors.
In the meantime, regulators should take this opportunity to study the effects of Alpha as an
unprotected and displayed market, before making any decisions about creating other unprotected
markets. This will only exacerbate a decision which we firmly believe will prove to be detrimental
to overall market quality.
4 http://www.osc.gov.on.ca/documents/en/Securities-Category2-Comments/com_20140926_23-101_petlockc-wiklanderj.pdf