Insight & Research / Wealth Management

What South Africa can learn from the US’s experiences in regulating trades across competing stock exchanges

Michael Lewis’ Flash Boys seems to suggest that speed is all that matters in today’s markets and in the modern world of High Frequency Trading (HFT). As Haim Bodek’s The Problem of HFT illustrates, the order types provided by exchanges and how much transparency they give to their members about their rules and matching engine practices are at least as important as speed.

This theme – speed of execution and the types of specialised order types on offer – is becoming important in South Africa following the launch of A2X

This theme – speed of execution and the types of specialised order types on offer – is becoming important in South Africa following the launch of A2X. From what we have seen unfold in markets such as Canada and Australia, the introduction of competitive stock exchanges brings significant change to the concept of ‘best execution’ in trade. The complexities increase exponentially with each new exchange that launches in a market.

From what we have seen unfold in markets such as Canada and Australia, the introduction of competitive stock exchanges brings significant change to the concept of ‘best execution’ in trade.

Regulation

There are no regulations yet to govern best execution in a South African multi-market environment. Because we are seeing the launch of competitive exchanges in South Africa years after many other countries, we have the luxury of cherry-picking regulatory practices that have worked without unintended consequences in other jurisdictions.

 

We can also look at examples of regulations blamed for creating adverse HFT activity, such as Regulation NMS 610 and 611 (RegNMS) in the US and avoid similar mistakes. Not all HFT activity is toxic, and taking risk and providing liquidity as a market maker is a service that should be appropriately rewarded. Regulation should strive to enable the benefits of benign HFT activity while curtailing predatory behaviour. Let’s take a closer look at how this works in the US.

Principles of the US National Market System

The National Market System in the US encompasses all the facilities and entities used by broker-dealers to fulfil trade orders for securities across stock exchanges such as NYSE and Nasdaq. The principles of the National Market System are simple: “Investors must be assured that they are participants in a system which maximises the opportunities for themost willing seller to meet the most willing buyer.”

 

What is less clear is the extent to which a fragmented marketplace achieves this goal. Supporters of the system argue the competition between exchanges adds liquidity and depth to securities markets. Detractors counter that price discovery is impeded by less competition within an order book and increased competition between markets trading the same stock.

 

In balancing the effects of competition between exchanges with those of competition between orders, the US’s Securities and Exchange Commission is guided by the “belief that one of the most important goals of the equity market is to minimise the transaction costs of long-term investors and thereby reduce the cost of capital for listed companies.”

The Order Protection Rule (Rule 611 under RegNMS)

The Order Protection Rule governs trade-throughs, which occur when one venue executes an order at an inferior price to the quote from another venue. This rule effectively forces exchanges to either reject marketable trade-through orders or route them to the exchange displaying the best price. In theory, this rule should enable investors to get the best price across all exchanges, no matter where the order is placed.

The unintended consequences of Intermarket Sweep Orders

In practice, however, the introduction of a new order type called the Intermarket Sweep Orders (ISO) enabled HFTs to undermine the ability of others to secure the best price. The ISO was introduced because institutions feared that the Order Protection Rule would reduce their ability to execute large block orders. Trading venues receiving ISOs can execute immediately without waiting for better-priced quotations in other markets to be updated.

To comply with Rule 611, market participants require access to the protected quotations of all venues. The Access Rule (Rule 610 under RegNMS) regulates the fees a venue can charge for quote feeds, allowing fair and efficient access to the best displayed prices. Many broker dealers chose not to permit clients to submit ISOs because of the burden of compliance and because brokers assume all liability for complying with the rule.

Spam-and-cancel

HFTs, however, took advantage of slow stock information provider (SIP) data feeds on price moves to get ahead of the market. To quote Haim: “While traditional orders based upon slow SIP data and trade-through routing chase SIP quotes that don’t exist, HFTs using ISO orders and fast data feeds can access rapidly diminishing liquidity on price moves and thus outflank the latency-prone tactics.”

Another strategy HFTs used to get around Rule 611 is ‘spam-and-cancel’, which takes advantage of the ‘price-slide’ feature exchanges introduced several years ago. Under price-slide, orders that could result in locked markets were ticked back and rested at the bottom of the queue at the prevailing best price. This created an opening for HFTs, which have the primary goal of being first in the queue. 

HFTs exploited price slide to gain queue priority by cancelling slid orders at the bottom of the queue and trying again, whereas price-slid institutional orders would remain at the bottom of the queue.

Hide-and-light

Another order-type was ‘hide-and-light’ in which orders that would otherwise lock markets were hidden. Once the absent market was no longer locked at that price level, the order would “light” up and become a displayed order. The effective use of these order types required an understanding of all the variables involved, from the rules prohibiting locked markets to the extent of special order types available and exchange matching engine practices.

Implications for South Africa

What does this mean for South Africa with the dawn of competition between markets? We can see that RegNMS had unintended consequences. While the principles driving the regulation are sound and prudent, there were knock-on effects that caused the evolution of intermarket competition. This FlexTrade article from April 2017 shows there is still much to do. 

The key questions that remain to be answered are when the FSCA will require best execution as a regulatory standard and if our financial intermediaries are prepared for the requirements.

The regulatory landscape in South Africa will no doubt lean on the progress made in the US and EU. The key questions that remain to be answered are when the FSCA will require best execution as a regulatory standard and if our financial intermediaries are prepared for the requirements.  

For IRESS clients in South Africa, familiarity with the pricing instructions and order lifetime differences between exchanges will be key. A knowledge of the fee structures between the various exchanges will also help to identify potential conflicts with the ideology of best execution. And using the latency normalisation functionality in our Best Market Router product can help limit the information leakage that might otherwise occur with sweeping market orders.

An AQR Capital Management publication titled Trading Costs presents an analysis of the trading costs borne by an institutional money manager over 19 years, 21 developed equity markets and $1.7 trillion of live executed trades. It shows that *the number of lit trading venues decreases price impact by 1.48 basis points per dollar traded*.

Conclusion 

An AQR Capital Management publication titled Trading Costs presents an analysis of the trading costs borne by an institutional money manager over 19 years, 21 developed equity markets and $1.7 trillion of live executed trades. It shows that the number of lit trading venues decreases price impact by 1.48 basis points per dollar traded.

Assuming that the results would generalise to South Africa, that the average daily notional volume traded on the JSE would be R15 billion, and that all listings on the JSE had a secondary listing on A2X, this would translate into a saving of almost R2.25 million per day or R560 million per year. 

This is a conservative estimate of the price impact since we believe the spread in a developing market would get greater benefit from intermarket competition than the developed markets that were the subjects of the study. There is hence much to be gained for the ultimate investor in South Africa from an increase in competition. 

Here’s to lower transactions costs, lower cost of capital and better execution.

Banner

More insight & research

This site uses cookies to store information on your computer. By using our site you accept the terms of our cookies policy. Accept