Aequitas Neo, Canada's new stock exchange, on mission to reshape capital markets
Start up stock exchange pitches fairness to investors
Nathan Mayer Rothschild was a pioneer in high-frequency trading.
Like the high-frequency traders of today, the powerful 18th century English banker used technology to make money on the stock exchanges.
According to legend, in 1815, Rothschild used carrier pigeons to learn the outcome of the Battle of Waterloo before anyone else. He used the news of Napoleon's defeat to his advantage, buying up government bonds at the exchanges before any of his fellow bankers clued in. He made a fortune.
"People will always look to have an edge," acknowledges Jos Schmitt, president and CEO of Canada's newest stock exchange, the Aequitas Neo Exchange in Toronto.
"But in those days, everyone could do it. It was not too expensive to own a carrier pigeon."
Today, Schmitt sees a select few having that edge. This elite group, he says, uses predatory high-frequency trading to gain an unfair advantage in the markets.
What is predatory high-frequency trading?
Exchanges are set up for the buying, selling and trading of securities like stocks, funds and other financial instruments.
To buy a certain amount of securities, a buyer may have to go to multiple sellers. This is where predatory high-frequency trading kicks in.
For instance, a buyer will set out to buy three $1 stocks.
A high-frequency trader will see the purchase of the first $1 stock. The high-frequency trader will then spring into action and buy up the rest of the available $1 stock. When the original buyer goes to complete her purchase of the other two $1 stocks, they have already been bought by the high-frequency trader.
Now the high-frequency trader will sell that $1 stock for $1.01 — often back to the original buyer — and pocket the difference.
This all happens in milliseconds.
These milliseconds, over hundreds of thousands of trades, create a lot of money.
"It's technological front-running," says Schmitt. "And it adds no value."
The standout goal of the Neo exchange is to stop predatory high-frequency trading. The new exchange aims to put a speed bump on those traders using predatory high-frequency trading.
The exchange is owned by a host of big-name stakeholders, such as OMERS Capital Markets, Barclays Corp. Ltd., Royal Bank and others.
Capital markets, then and now
It cost $5 to join the Toronto Stock Exchange.
That was decided on October 25, 1861, when Toronto's first official exchange was founded.
That day, 24 businessmen met at the Masonic Temple to devise a plan to trade financial instruments and raise money for business in Toronto. Before that, capital needed for businesses was raised on exchanges in London, England — which was both inconvenient and counter to the budding efforts of the Canadian confederation.
So the Toronto Stock Exchange began. It was owned by its members, who would spend a half an hour each day, trading all of 18 securities, mainly in the bank and real estate industries. The new exchange reported a volume of about five or so trades per day.
The Toronto Stock Exchange now trades around 230 million shares per day, according to the Investment Industry Regulation Organization of Canada, and is no longer mutually owned by its members. The stock exchange owned by a for-profit corporation, TMX Group Inc., handling a vast majority of the capital markets in Canada.
This evolution of the exchange is part of the problem for Schmitt.
"Exchanges are very supportive of high-frequency trading," he says. He believes Canada's stock exchanges have outlived their usefulness.
For-profit exchanges thrive off volume of trades, and high-frequency trading adds to volume, he says.
Part of eliminating the bad behaviour on the stock markets, then, is governance. Instead a public company, the Neo exchange is governed by investors and issuers, all with an equal share.
This avoids the drive to deliver value to shareholders — mostly accomplished by volume of trades.
Ontario Finance Minister Charles Sousa says he doesn't have an opinion on high-frequency trading — that is up to regulatory bodies like the Ontario Securities Commission.
Sousa spoke at the Neo launch, but stresses he is not passing judgement on any exchange.
"That's a choice investors can make," he says of high-frequency trading. "I trust them to make that choice."
But Sousa says the fact the choice is now available to investors is a good thing.
"This will be great overall," he says. "My only desire is to increase competitiveness."
The benefits of competition may already be arriving.
TMX Group has altered its approach since Neo received its regulatory go-ahead. In October 2014, it proposed a wave of reforms to its trades. Those include effective solutions for participants who do not use speed-based trading strategies, according to Kevan Cowan, president, TSX Markets and Group Head of Equities.
Part of those reforms are to give high-frequency technology to more investors.
TMX is awaiting approval of its measures.
In the interim, Cowan points out TMX is in full compliance with Universal Market Integrity Rules, and adheres to principles of fair and transparent markets.
All about investor confidence
But for Schmitt, considerable damage has already been done.
He says the recent history of the stock exchange in Canada, including the switch in its ownership from mutually owned to a public company, has contributed to what he calls a "deep investor confidence crisis."
He argues that is caused by the perception that markets are not fair anymore.
"There are behaviours in the markets today which make it very difficult for a retail investor to be successful," says Schmitt. "That type of behaviour is what we want to eliminate."
Fundamentally, you no longer have to know about the fundamentals of a corporation to invest in it, says Schmitt. You just have to see what other investors are buying and use high-frequency trading to get there first.
So that does not come down to investor know-how, but the wealth to invest in high-frequency trading technology.
"That confidence crisis has an impact. If people don't feel confident, they will not come to the market," he argues. "And if people don't come to the market, you have problem raising capital. If you have problems raising capital, you have problems growing your economy."