National Post, 21 May, 2014, p. F11
Canada’s investment industry behemoths – aided by misguided regulators – are plotting to shut out upstart competitors to the detriment of investors
In his magnum opus “The Wealth of Nations,” Adam Smith, the über mensch of competitive markets, famously opined that “people of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.” It turns out that Canada’s securities dealers have been doing quite a bit of partying lately. The remarkable thing is that, in their proposed amendments to the Canada’s securities market trading rules released last Friday, Canada’s securities regulators are supplying the beer and wine.
The core principal underlying today’s fragmented securities market, and the engine of competition and innovation, is the “order protection rule” (OPR). As the regulators’ report states, this rule ensures that the “best-priced displayed orders should generally be executed before inferior-priced orders.” The rule is advantageous for a host of reasons beyond merely giving investors the benefit of the best price possible.
For one, it is indispensable to public confidence in securities markets. Suppose that investors see that their orders are being executed against inferior-priced orders, or perhaps not executed at all, while inferior-priced orders are filled. This kind of monkey business is a reliable hallmark, at best, of professional negligence; at worst, of professional misconduct. It gives the impression, amply justified, that the insiders are rigging the markets to the disadvantage of the outsiders – who just happen to be their clients. As the Gershwins so eloquently put it in their 1937 hit song – “nice work if you can get it.”
The OPR also fosters competition and innovation in securities trading. Without it, the behemoths of the industry (the TSX, TSX-V, Alpha, and the bulge-bracket investment dealers who own them) can simply run a private little shop where they internalize all of their client order flow, never having to worry about outside competition. The OPR, by creating “virtual consolidation of the central limit order books from each visible market” (as the report puts it), allows small upstarts to compete against the industry giants by building faster, more efficient, and better-priced trading engines, and attracting order-flow away from the gorillas.
Since the regulators permitted off-exchange trading in listed securities, this has happened in spades. But more importantly, the superior technology introduced by the gadflys has forced the incumbents to radically upgrade their own trading platforms. Bid/ask spreads have narrowed, the cost of trading has plummeted, and investors now have at their disposal a variety of trading options that did not exist before.
But now the securities dealers, horribly piqued at seeing their bottom lines plummet from this unwelcome competition, have contrived to put the gadflys out of business by convincing the regulators to limit the operation of the OPR to marketplaces with at least a 5% market share. The result would be that the trading venues owned by the investment dealers – the TSX, TSX-V, and Alpha – would have a virtual monopoly on the business of trading listed securities. Only a single competitor (Chi-X, a division of Japanese giant Nomura Securities) would be left standing. Perhaps the incumbents feel that, given their pedigree, Chi-X will prove an acceptable member of The Club.
Even worse, should the change be implemented, securities trading would no longer be a “contestable market”; that is, one open to new entrants. How can you start up a competitor to the incumbents when you need a 5% market share to get the benefit of the OPR? No matter how good the bid and ask prices you post, the market incumbents can ignore you and direct their order flow elsewhere – i.e. to their captive platforms. Without that order flow, there is no hope of succeeding. What a cagy little way to erect a permanent and insurmountable barrier to entry.
It is important to recognize, as economists do, that it is not merely the vitality of the current competitive landscape that keeps incumbents honest. It is the threat of competition. Without that threat, the oligopoly can essentially operate as it chooses. It can overcharge and underserve its customers, underinvest in technology, and turn a blind eye to innovations being adopted everywhere else in the world. Nice work indeed.
In part, the regulators’ justification for the proposed change to the OPR is that it “necessitates that participants trade with the best-priced displayed orders, regardless of the level of fees charged by marketplaces displaying those orders.” This is actually quite amusing, since it is the incumbents themselves that have the highest trading fees, and not their upstart competitors. In fact, the real problem is that the incumbents habitually route orders to their captive trading venues when there is a tie in price, even when their competitors charge much lower trading fees. They do this simply to keep order flow out of the hands of their competitors. Where do our securities and competition regulators stand on this one?
Other justifications for the proposed rule focus on the ostensibly excessive cost of implementing the current OPR. These include: the cost of physically connecting to each and every other trading venue; the cost of securing a live data feed from every venue; the cost associated with breaking up orders between a variety of markets in order to secure best execution for the customer (even though institutional investors actually like to do this to disguise their block trades); and the back office costs of sorting out all the trades. These arguments are pure smoke and mirrors. If the incumbents’ smaller competitors can pay the freight and still be profitable, what’s the problem with the big dealers? Even aside from the fact that these various costs are a fleabite compared to the revenues and profits of the behemoths, the bulge-bracket dealers and their captive trading venues still have the lion’s share of the order flow. They can therefore exploit economies of scale not open to their smaller rivals. And yet, look who’s complaining.
It’s not like there’s a rabbit warren of competitors out there racking up costs for the deeply put-upon leviathans. Currently, the competitive landscape (aside from the incumbents) consists of Chi-X (which operates two services), Pure/CSE, and Omega. It is unlikely that there will be a shower of additional entrants. The difficulty and expense of wending one’s way through the regulatory apparatus to secure a trading license is a sufficiently daunting barrier to entry that these various costs will naturally be contained within reasonable limits.
In addition, in relation to the existing field of competitors, physical connection costs are past and not current or future expenditures. If the dealers want to be consistent in their whining and sniveling about undue connection costs, they inevitably must argue that all current competitors should be grandfathered out of any change to the OPR. Curiously, neither they nor the regulators seemed to have twigged to this one.
There are other astonishing aspects of the report. The OPR has always been seen as a vital mechanism for fostering investor confidence in securities markets. But the report actually endorses the extraordinary argument that “many investors, and retail investors in particular, are likely not aware of OPR and its implications for their orders,” and “the true impact of OPR might not be evident unless the rule was to be loosened or repealed.” In other words, we need to dump the rule so investors can appreciate how important it is. Funnily enough, after investors figure out what they’re missing, the report evinces no intention of reinstating the OPR. This is Orwellian doublethink on a Herculean scale.
Added to this, the report asserts that many of the orders appearing on alternative trading venues are placed by “professional traders, whose confidence in the fairness and integrity of the markets would be least likely to be negatively affected in a material way in the absence of the rule.” Oh really? Even supposing that the underlying factual supposition is correct, are we to believe that professional traders do not care about fairness in securities markets? That they are blasé about getting the best price available, and just laugh it off when their orders are shunted onto an inferior-priced order? Even Don Quixote would be startled by the fictive character of this argument.
The poor impecunious securities dealers and their captive marketplaces also plead “frustration over their inability to better manage the scope and timing of their technology spend given the implications of OPR for their technology resource allocation.” Oh, you poor little things. Imagine – competition can be tough! It can be expensive! It can be frustrating! But once again, if the small fry can handle it, why can’t the whales?
In truth, much of what the report focuses on is irrelevant to the public policy issue at hand. The report focuses almost exclusively on the costs incurred by dealers and marketplaces in complying with the OPR. It then vaults to the conclusion that many of these costs are manifestations of “trading inefficiencies” and the cause of “broader market inefficiencies.” What a clever bill of goods the goliaths have served up on our hapless regulators, who seem to have forgotten that their statutory mandate is not to protect industry profits or those of a particular segment of the industry, but to protect investors. Vigorous competition means thinned-out margins. So what?
The report also states that the regulators’ “review of the costs and benefits of OPR” support the proposed change. This is highly misleading. The report’s “review” of costs and benefits is completely qualitative; not a single fact or figure bearing on any of the “reviewed” costs graces any page. Moreover, the view that certain costs that extend from the current OPR are “excessive” and “unreasonable” is derived entirely from the deeply self-serving testimony of interested players who would just love to see competition come to a screeching halt.
It is no answer that all marketplaces were consulted. The incumbents have the swagger, the prestige, and the resources to out-pitch their smaller competitors (at least, to the extent that form may triumph over substance). It is difficult not to be reminded of one of the seamier sagas in American corporate history, when Big Tobacco’s seven CEOs lined up before Congress to sanctimoniously proclaim, one after the other, that “smoking is not addictive.” The Canadian securities dealers have coordinated their script with commensurate care. And the result is no less ridiculous.
Were Adam Smith alive today, he would almost certainly add an addendum to the admonition quoted at the outset. In today’s highly regulated world, commercial parties will often find that they can best achieve their aims by bending the ear of the regulator to an imaginative and quixotic tale nominally grounded in serving the public interest, but which in fact serves naught but their private interest. It is the job of regulators to resist these siren calls. In this instance, ours earn a clear and convincing “F”. If they and the securities dealers want to take Canadian capital markets back to the Dark Ages, perhaps they should set up shop in Albania.
Jeffrey MacIntosh is Toronto Stock Exchange Professor of Capital Markets at the Faculty of Law, University of Toronto, and a director of CNSX Markets, which operates the CSE/Pure Trading facility. The views expressed here are his own, and not necessarily those of CNSX Markets.
