Stock Exchanges and Innovation

RPavalow (November 2016) 1

Challenges for Stock Exchanges to Innovate

By Randee Pavalow

November, 2016

Every thriving and growing entity must learn to change and adapt to be successful. This is neither a profound nor a new idea, yet we see more and more attention being paid to the concept of innovation – what it is, how important it is and how do we achieve it. This may be so because of the complexity of our environments (integration of multiple parts), speed of change, extent of impact, and difficulty of the challenges. The challenges can come from the business culture including client resistance, dated regulatory structures, competitive forces and issues related to the size of business verses the costs.

This paper looks specifically at how stock exchanges may try to innovate and the challenges they face1. It discusses the following:

Nature of Innovation and key conditions Stock exchanges and how they have innovated Challenges that inhibit successful innovation and some recommendations Conclusions

1. Nature of Innovation and Required Conditions

Steve Grob, in an article published in Tabb Forum on September 3, 2016, identifies two sources of innovation: (1) that which adds differentiating value to demonstrate relevance; and (2) that which helps reduce cost2.

A firm seeks to add value or reduce costs for its customers so it can: generate revenue, increase profits, respond to competitive pressures, or address new industry and regulatory requirements (or all of the above). However in order to achieve successful innovation, there needs to be certain basic elements.

These basic elements create the ecosystem3 for change and include: 1 The analysis in this paper is based on my personal observations as well as experience as both a regulator and an executive at a marketplace; however, these views are my own and do not reflect the views of any organization where I have been employed.

2Grob suggests that in the financial services world, recent regulation has lead to disintermediation which challenges and weakens the value that intermediaries used to provide.


a. Expertise – technical and managerial, b. Funding or capital, c. Cultural or openness to risk and change, and d. Governmental/Regulatory.4

Skills/Expertise. A knowledgeable work force is key to identifying and implementing innovative solutions. This requires both a good educational system as well as experienced people.

Capital. Capital is required to support entrepreneurs as they try to grow their business. The amount and source of capital often changes over time (for example, seed capital from angel investors or growth capital from private equity investors).

Cultural/ Openness and Risk Tolerance. Any business entity that finds new solutions or ways to do things, has to find early adapters who are willing to invest the time and money to try the new opportunity. If parties are being successful with current products and opportunities, it can be very challenging to convince them to try something new. This means it is also helpful to identify ways to mitigate the risks associated with changes in order to encourage more openness. New opportunities and the likelihood of success must be identified to address perceived and actual risks. Most risks can be managed rather than avoided.

Government/Regulatory Environment. Consumer protection has become increasingly important to government. At the same time, business development is also an important mandate for all levels of government. Public policy and government initiatives need to balance these and other objectives in order to promote economic development.

The ecosystem approach is used because it enables both practitioners and policy makers to focus on the “collaborative, interdependent nature of the innovation process and identify the best means of stimulating productive networks and relationships between firms and a range of support organizations5.” The ecosystem approach was used in this paper to look at stock exchanges because of the belief that in the complex and integrated public securities markets, it

3 The terms “entrepreneurial ecosystem” and “innovation ecosystem” are both widely used in the literature. 4 The basic elements of the innovation ecosystem seem to be the same for different industries even though different analysts may use different names for the categories. For example, In the Current State of financial Technology Innovation Ecosystem in the Toronto Region (Report from the Innovation Policy Lab of the Munk School of Global Affairs), the authors quote Daniel Isenberg and point to: culture that is supportive of innovation, adequate supply of financing, access to well-educated human capital, access to markets for the products or services. The report also highlights the critical role of government. 5Dan Breznitz, Shiri Breznitz and David A. Wolfe, “Current State of the Financial Technology Innovation Ecosystem in the Toronto Region (Munk School of Global Affairs).


is more effective to focus on a range of network influences rather than on individual institutions.

2. Stock Exchanges and how they have innovated

In order to consider issues around innovation for stock exchanges, it is important to understand the commercial aspects and business constraints. Historically, stock exchanges6 provided listing, trading, data and regulatory services. Some stock exchanges also provided clearing and settlement services. They were not-for-profit membership organizations which focused on services for listed companies and their members who were dealers. After stock exchanges became demutualized and for-profit entities, the desire to find new sources of revenue increased and lead to the stock exchanges becoming involved in other business lines such as investor relation services and order routing. This section describes the services provided by stock exchanges and some specific examples of past innovation.

Listings. Stock exchanges identify which securities may trade on their stock exchange through an application process known as listing. The listing process is a vetting process that the stock exchange uses to establish that the issuer meets certain initial and on-going standards set by the stock exchange.

The listing standards focus on (1) financial criteria (market capitalization, cash flow, or other characteristics of a company or fund) to establish or maximize the likelihood of the issuer being able to grow and continue on an ongoing basis; and (2) minimum number of security holders and board lots to establish liquidity. Exchanges may also establish requirements regarding transactions (e.g. review of material acquisitions) and disclosure of information (e.g. corporate governance practices). The purpose of these kinds of requirements is also to maintain the quality of issuers by setting minimum financial and liquidity criteria7. .

In Canada, the securities offering is also subject to prospectus requirements and approval by the provincial securities regulator(s). Generally new securities types or characteristics will be reviewed with the securities regulators as well as the stock exchange before an application for listing is made, as part of a “pre-filing process”.

Exchanges may try to innovate by introducing new types of securities (the introduction of exchange traded funds was this type of an innovation8). It may also innovate through its listing requirements. For example, Aequitas NEO Exchange Inc. (NEO), which began operating in 6 This paper discusses stock exchanges that trade equity type products but may also be applicable to derivatives exchanges as well. 7 One could also argue that these criteria provide investor protection, but that is more of a side benefit than part of the exchange’s mandate. 8 The TSX introduced the Toronto 35 Index Participant Units (TIPs) in March, 1990.


March, 2015 took a different approach towards the approval of material transactions. It decided to leave the responsibility for approval to the board of directors and shareholders of the listed company because it reduced the time to complete a transaction and left the decision to those who had the direct interest. NEO also introduced a requirement regarding analyst coverage or investor relations budgets.9 This requirement was added because analyst coverage supported issuer and investor interest in liquid markets for securities by making information about the company available. In the case regarding the review of transactions, NEO looked to what its competitors in the U.S. were doing; and in the case regarding analyst coverage, it introduced a new requirement based on its philosophy that information about an issuer is key to supporting liquidity.

Trading. One of the main purposes of a stock exchange has been to enable intermediaries (dealers representing their own and their clients’ investment interests) to be brought together in one place to exchange information and interests to buy and sell the securities listed on the stock exchange.10 In order to achieve that purpose, stock exchanges establish trading rules that cover access requirements (who may enter orders), market structure (order types and rules of interactions among participants including the role of market makers), and any related conditions such as settlement. The purpose of these rules is to maximize efficient price discovery and liquidity as well as reduce risk of errors and settlement failures.

In regards to trading, stock exchanges may try to innovate by introducing different types of orders, rules for matching trading interests (orders) and trading fees. For example, passive only orders11 was a new type of order that was introduced to take advantage of the maker taker fee model which provided a rebate for passive orders that were entered and made transparent before being executed. The maker taker fee model was originally introduced by new marketplaces which were looking for ways to compete with the incumbent exchanges.12 Passive only orders were introduced based on client demand, while the maker taker fee model was introduced out of the need to compete and attract liquidity.

Another example is in regards to access to trading. Access to trading was limited to members when the exchanges were mutualised. Trading took place on the physical floor where there were space limitations. Moving to electronic trading removed any physical restrictions and allowed access to a greater number of participants. As a result, stock exchanges began to allow

9 Listing Manual, Aequitas NEO Exchange Inc. 10 National Instrument 21-101 sets out the criteria that determine whether an entity is an exchange or other type of marketplace. 11 Passive only orders are orders that are rejected if they would be executed without being entered in the order book. They can only be traded if they are in the order book when an execution takes place so that any rebates applicable to passive orders are received. 12 SEC, Memo to the SEC Market Structure Advisory Committee (October 20, 2015) on Maker-Taker Fees.


the members’ clients to have direct access to place their trading interests, provided the member remained responsible and monitored the activity.

Data. Stock exchanges have information on orders and trades (market data). This market data is provided both to direct participants or members of the exchange, as well as other parties who need the data for trading decisions or other reasons such as risk management and compliance.

Market data was always made available to the member of the exchange to enable them to trade. Over time, more and more parties (such as institutional investors, retail investors on discount platforms, back office functions of firms to price or monitor risk) wanted access to this information to assist in making trading decisions or for other purposes. As a result, exchanges began to package their data and make it available to other parties for a fee. Although additional products have been added, arguably this area of exchange business has seen very little innovation in terms of how information is being provided. Most of the changes that have occurred have been as a result of changes in regulation regarding transparency and information requirements.13

The creation of an approved information processor was one change that was initiated by a change in securities laws. National Instrument 21-101 (NI 21-101) created the concept to encourage the creation of consolidated market data as a result of competing marketplaces. It was introduced to address the concerns regarding fragmentation of trading opportunities that could occur with multiple trading venues. The TMX Group did apply and was approved. While this initiative did address the fragmentation issues it also raised issues regarding the cost of data.

Regulatory. Historically stock exchanges were considered regulators because they not only established rules,14 but also enforced them through conditions on or denying access. The rules were the listing standards and trading rules.15

Regarding their regulatory functions, stock exchanges have adopted technologies that allow more efficient regulatory processes (such as electronic filings) and better monitoring. In addition, with demutualization there has been a push to outsource some of the regulatory functions to self regulatory organizations such as the Investment Industry Regulatory

13 NEO has announced it is working on a solution to reduce costs, but its efforts have been impacted by contractual limitations that it has argued are anti-competitive. 14 There are other organizations that set codes of conduct but cannot take any action other than identify non-compliance (reputation effect). 15 In more modern times, the line has become more blurry with the establishment of alternative trading systems and other service providers such as order routers which also have “requirements” but only have recourse through contractual remedies.


Organization of Canada (IIROC) in Canada. In Canada the stock exchanges retain IIROC for oversight16 and enforcement of market regulation and violations related to material news regarding a listed issuer. This was done as a result of securities regulators’ concern regarding the conflict that could arise when stock exchanges were for profit. The concern was that the exchanges would sacrifice spending on regulatory functions in order to maximize opportunities for profits.

The key changes to the stock exchanges’ regulatory functions have been driven by the securities regulators and regulation. Examples of this in Canada would be the implementation of the Order Protection Rule requirements (National Instrument (NI) 23-101), Single Stock Price Bands (Rule 10 of IIROC’s Universal Market Integrity Rules (UMIR)), and Error Correction Policies (rule 7.11 of UMIR and National Instrument 23-103). This had lead to the stock exchanges becoming more and more homogenous in the trading services they provide.

Governance and Ownership. The ownership and board structure of exchanges have gone through changes since demutualization. Stock exchanges were originally non-profit entities owned by the participants who had access and traded (the members). The board consisted of representatives of management and members of the exchange who were also the users. Since the late 1990’s, many stock exchanges have become for-profit publicly listed companies (moving from mutualised to demutualized entities). This was done to enable the entity to be able to be more innovative and commercially driven. Out of a concern that the stock exchanges would drain resources from the regulatory function to areas that generate revenue as well as the more general movement in corporate governance for public companies, independent board representation was required by the securities regulators.

Attracting investors who both understand the business and can help to support its success is key to new businesses (strategic investors). Also, investors in new initiatives want to have oversight and influence on the business in order to mitigate the risk of the investment. Aequitas NEO Exchange introduced a hybrid ownership structure where there was a small group of significant investors, however any other exchange participants would be allowed to become owners in an attempt to remutualize and bring users (strategic investors) into the ownership structure. In a departure from the historical model, it also made a commitment that over 50% of the ownership would be with buyside institutions and issuers. This was intended to make sure that the ownership structure reflected all of the users and not just the member dealers. Board representation also reflected this inclusive approach so that each group could have oversight and input on the business.

16 The stock exchanges and ATSs have each entered into a Regulation Services Agreement with IIROC. The services are standardized and the same for all stock exchanges and provide very limited involvement for the stock exchanges.


Other services. After stock exchanges became for profit entities, they began to expand into other revenue producing activities. These services were often related to and include order routing, corporate relations, and data analytics.

3. Context for innovation, current issues and recommendations

This section evaluates the ecosystem for stock exchange innovation including the challenges and some recommendations for consideration. The recommendations are not intended to be a laundry list of suggestions, but rather some suggestions to generate discussion and promote innovation.

Skills/Expertise. A knowledgeable work force is key to identifying and implementing innovative solutions. This requires both a good educational system as well as experienced people to provide executive and managerial skills. In Canada, there are many individuals and institutions (both private and public sector) with expertise in market structure and corporate finance issues. In fact, Canada has created innovations that have been exported outside of Canada. For example, the concept of segmented retail access to dark trading facilities was pioneered at Alpha Trading Systems and afterwards implemented, with some modification, at the New York Stock Exchange17 and other marketplaces.

The issue is not whether there is skilled labor but rather whether there are enough opportunities to keep its skilled people in Canada. Without those opportunities, Canadians will leave Canada to advance their careers. In order to create opportunities and keep skilled labor, Canada needs to be perceived by skilled people as an internationally competitive market where new businesses and ideas are welcomed and nurtured. On the supply side of opportunities, new businesses including stock exchanges need to feel welcome and believe they can succeed. There is also a role for senior people in current organizations to encourage and support other initiatives which can complement the operations of the stock exchanges and businesses related to the trading of public companies. Thus the other ecosystem factors of culture, funding and policy play an important role in creating an environment where our talented people want to stay in Canada. The failure to provide opportunities will mean that our skilled participants will leave to go elsewhere. Recommendation

Senior people with capital markets experience and expertise should support talented people by providing time and access for young entrepreneurs. This will help to create a competitive

17 Alpha introduced IntraSpread in 2011, and the NYSE introduced its Retail Liquidity Program in 2012.


environment for business initiatives which build or complement the operations of the stock exchanges and businesses related to the trading of public companies. This can be done by dedicating time for mentoring and advising. Also, senior people are a good resource for extending networking opportunities within or external to their own firms.

Capital. Capital is required to support innovative business initiatives by enabling them to develop new ideas and expand business opportunities. A stock exchange is highly dependent on technology and regulatory resources, both of which are very expensive. For example, legal fees to support a recognition process can cost up to and even more than a million dollars if provided by outside legal counsel. Moreover it takes time for an exchange to attract liquidity and listings in order to generate revenue. Starting a new stock exchange and getting it to cash flow positive may require tens of millions of dollars.

Capital is available to invest in new marketplace initiatives but actual investment will depend upon the assessment and mitigation of the risks. The more innovative the proposal the higher the risk. These risks include the high uncertainty of regulatory approval and client adoption. The fact that incumbent exchanges have brand recognition and that liquidity tends to attract liquidity puts the incumbent stock exchange(s) at an advantage for listings and trading that may be difficult to overcome. Investors will want to know how the risks will be mitigated. As a commercial entity, a stock exchange has to have similar tools to other businesses to mitigate or eliminate risk in order to attract capital investments.

The Ontario Securities Commission was very helpful in addressing the regulatory uncertainty when NEO was developing its proposal, by allowing a comment process on the proposal before the formal application was made. This process helped to narrow the issues and therefore the risks.

In the past, new exchanges and marketplaces have used shareholder incentives (e.g., redetermination agreements which allow old shareholders to increase ownership or new shareholders to acquire shares through achieving performance objectives), as well as fee incentives such as the maker taker model to attract liquidity. These types of incentives have faced increased regulatory scrutiny and made raising capital to start a new exchange more difficult. The Maple and NEO recognition orders specifically prohibited providing any discounts or incentives.18 Reconsideration of these prohibitions or consideration of new ideas need to be discussed because like any other businesses, stock exchanges need the flexibility to address the risks associated with operating their businesses.

18 See Schedules to Maple Recognition Order setting out terms and conditions related to fees.


Recommendation:

Flexibility should be allowed so that new entrants can have a potentially viable business model by having tools to mitigate risks.

To address regulatory uncertainty, a pre-filing approach similar to the one that was employed by the Ontario Securities Commission on the NEO application should be adopted19.

To address commercial risk, a more flexible approach to shareholder ownership, listing and member incentives should be used.

Also consideration should be given to an approach that allows different requirements at different stages of growth. For example,20 special fee incentives may be allowed until a new entrant reaches a specified trading threshold (i.e., performance rewards (fee rebates) until the stock exchange reaches 5% trading volume).

Culture/ Openness and Risk Tolerance. Key inhibitors to change are costs, general inertia to change and unwillingness to take on risk. The causes impacting the low tolerance for risk include the complexity of the markets, role of technology, regulation, and culture.

Complexity and role of technology. In order to operate a stock exchange, the exchange must manage and be integrated with: (1) companies who list, (2) dealers and their customers who trade, (3) data consumers and product providers, (4) service providers (such as routers, back office providers), (5) settlement agents, and (6)regulators. By the first day of operations, an exchange is likely to be connected to a hundred or more different entities, who must have access and be integrated into the technology of the exchange. Although most of the market participants have sophisticated hardware and application, the efforts to integrate are made more difficult because the systems are generally closed and proprietary. Any future changes by a stock exchange will continue to impact most of these parties and require extensive co-ordination in the testing and roll-out of the changes21. This can cause time delays as well as resistance to the changes because the users have their own priorities. General Inertia. Any business entity, including stock exchanges, that finds new solutions or ways to do things has to find early adopters who are willing to invest the time and money to try the new opportunities. If parties are being successful with current products and opportunities, it can be very challenging to convince them to try something new22. It is easier to convince

19 The OSC has recently initiated Launchpad to support innovation and new ideas coming into the market. 20 Any flexibility should not override any best execution or other obligations to clients. 21 S. 12.3 of NI 21-101 sets specific requirements regarding timing of technology requirements and testing facilities. 22 Woods, intra, reports that a 2015 report from CIBC Capital Markets identifies legacy systems, bureaucratic tendencies, and entrenched biases as endemic to the financial services industry.


people to try something new if they are struggling or perceive problems. For example, the creation of NEO was based on creating solutions to current issues in the capital markets including concerns regarding the speed advantages of certain market participants. Many buyside investors and other capital market participants expressed frustration because they felt disadvantaged against those traders that invested heavily in tools that created time and information advantages. A huge effort was still required to attract early adopters because the proposal consisted of a solution that did not exist in the marketplace and, therefore, it could not provide any data to prove the actual or potential results of its market structure innovations. Its arguments were based on the fact that the solutions addressed the issues.

In Canada, some have argued that Canadian businesses are risk adverse in that they do not like to be the first to try things. Over and over again, when you talk to business innovators they say they have been told they must prove adoption and success or their product in the U.S. first. This may be due to: a cultural issue, one related to scale, the fact that there tends to always be a few dominant players, or historical integration and reliance on the United States.

Incentives are not only useful to overcome concerns about investment risk but also to overcome cultural resistance to changes. In other sectors this can be done through fee promotions, special services or creative design (the “cool factor”). This is particularly important for a new marketplace which needs to attract listings and order flow. In the past we have seen marketplaces, including exchanges, try to do this through special arrangements (redetermination rights) and services focused on a group of participants such as institutional investors.

Proprietary Closed Systems Vs. Open Source. The financial services industry was an early adopter of technology but generally adopted closed proprietary solutions. This was due in part to its culture of focusing on security and control over information and operations, as well as its ability to internally develop its technology solutions. For many stock exchanges, the largest function as measured by number of employees is technology.23

Another approach to consider is how others are encouraging innovation. In an effort to stimulate innovation and address the network required to support innovation, there have been various initiatives to create centers of expertise and innovation labs. In some cases, parties have joined together to establish common technology standards and labs for testing the impact of new innovations. An example is R3, a blockchain technology company that includes a consortium of more than 70 of the world’s biggest financial institutions. The consortium has created an open-source blockchain platform called Corda geared towards financial transactions. The aim of Corda is to provide a platform with common services to ensure that any services are

23 Many stock exchanges currently identify themselves as technology businesses.


compatible between the network participants, whilst still fostering innovation and faster time to market as the underlying infrastructure would be accepted and understood by a large number of key financial institutions.24

Albert Voight in his article, “7 Ways an Open Fin Tech Ecosystem Will Change Financial Services” (Tabb Forum October 24, 2016), states that the financial trading environment looks remarkably like the early days of mobile phones because of its closed and proprietary nature which causes more manual intervention, redundant cost, wasted time, gaps in data and greater risk of human error. He argues for the adoption of an open platform analogous to the mobile world because, among other reasons, it empowers users to drive the innovation process and enables all player to create apps (and not just data providers). In considering alternatives, it must be acknowledged that there have been criticisms and questions regarding the effectiveness of these types of initiatives. There is no systematic evidence of their success. Part of the issue, is the lack of specific objectives, measurement and quantifiable results for evaluating the new approaches. It is important to identify the objectives and make sure they are measurable. This will not only define success, but keep market participants focused on creating successes. Like liquidity, success attracts success.

Recommendation

Develop incentives to overcome inertia and perceptions of risk.

Take an integrative approach to create efficiencies for the innovation ecosystem. Private and public sector should work together not only to create structures such as labs that enable open platforms, but also to create clear objectives, identify common technical standards and make data available to measure and identify successes because standardization and the creation of open access labs would facilitate working together.

Regulatory Environment. There can be barriers to change created by the approval process as well as the standards used to evaluate the changes that are being introduced. This section discusses the process for approving changes and the specific requirements of fair access, best execution, investor protection and public interest mandate.

Recognition and Approval Process. In order for a stock exchange to be able to operate it must receive approval from the regulator (evidenced by a recognition order and review of significant changes). This approval is intended to allow the regulator to review the governance, access,

24 Wikipedia entry on R3 (November 2016).


regulation of participants and issuers, rules and rulemaking, due process, clearing and settlement, systems and technology, financial viability, and fees.

The process for approving a stock exchange was never set out in the securities act. Section 21(2) states that the “Commission may, on the application of a person or company proposing to carry on business as an exchange in Ontario, recognize the person or company if the Commission is satisfied that to do so would be in the public interest.”

The approach was principle based in that each stock exchange application was reviewed as a unique application with terms and conditions based on the nature of its business model. This approach was also feasible because there were so few exchanges so customization and applying principles was not a burden. However over time, the terms and conditions have become more standardized regarding the operation of marketplaces and stock exchanges. Thus the recognition process has gone from principle based to a more prescriptive approach which establishes many of the same requirements for each stock exchange.

The following is an example of a detailed term and condition that is being applied to exchanges:

“The recognized exchange shall not, through any fee schedule, any fee model or any contract, agreement or other arrangement with any marketplace participant or any other person or company, provide:

(i) any discount, rebate, allowance, price concession or other similar arrangement on any services or products offered by the recognized exchange that is conditional upon the purchase of any other service or product provided by the recognized exchange or any affiliated entity;

(ii) any discount, rebate, allowance, price concession or other similar arrangement that is accessible only to, whether as designed or by implication, a particular marketplace participant or any other particular person or company; or

(ii) any discount, rebate, allowance, price concession or other similar arrangement for any service or product offered by the recognized exchange that is conditional upon:

(A) the requirement to have a Maple marketplace be set as the default or first marketplace a marketplace participant routes to, or

(B) the router of a Maple marketplace being used as the marketplace participant’s primary router.”25

25 See Maple Recognition Order and Aequitas NEO Exchange Recognition Order.


In addition to a more standardized prescriptive approach, staff at regulators look at precedent when evaluating the stock exchange. This means they compare what the new stock exchange is proposing to what current stock exchanges are doing. While current practices can be an important input, this focus on the existing stock exchanges creates uncertainty regarding the results and timing of required regulatory approvals when new things are being introduced. For example, NEO had initially sought to introduce a trading facility that disclosed trading interests but the price was established by reference to prices available on all marketplaces (the National Best Bid and Offer). It combined attributes of lit and dark trading facilities which did not exist at the time. Not only was there no precedent but also the regulatory rules had been created for separate lit and dark trading facilities. As a result it took almost 12 months to resolve this issue through a pre-filing process. Thus reliance on precedents and current models lengthens the approval process and also creates a culture that tends to be risk adverse.

Competition is often a source of incentives for innovation as well as reduces the risk of innovation; however it has also become a barrier in the stock exchange context because of the regulatory comment process. Recognition proposals and changes to business model are subject to public comment. This was originally intended to give an opportunity to those who were impacted (particularly investors and issuers) to provide reasons why they had serious concerns or believed there were important benefits. In the last few years, other stock exchanges and their owners have gotten more and more involved in making comments on changes being introduced by their competitors for competitive reasons rather than public interest concerns. This has caused delay in the approval process. In addition, an exchange who has criticized a change often will duplicate the same change after it has been approved26.

Requirements: Fair Access. One of the predominant issues facing stock exchanges and marketplaces is the concept of fairness, in particular fair access. The current position of some regulators and some participants is that fair means the same - that is that all participants must be treated the same. This ignores the fact that the current trading environment is complex and that different participants have different needs or desires. It also undermines the stock exchange’s ability to respond to these complexities and to compete27.

26 TMX objected to NEO’s implementation of a speed bump, but later adopted similar functionality. 27 Andrew G. Haldane, “Rethinking the Financial Network,” (April 2009 Speech delivered at Financial Student Association), argues that the combination of complexity and homogeneity creates an environment for a crisis to happen.


Requirements: Best Execution and Order Protection Rules. In addition, regulatory requirements such as Best Execution and Order Protection Rules28 may not give customers options regarding whether and when they can adopt the changes. While Best Execution requires a dealer to make reasonable efforts to achieve a trade on the most advantageous terms; the interpretation of the current regulatory position has been to focus on price and require access to all marketplaces. Size, value or number of orders is seen as less relevant, even where these factors may be important to the client29. The Order Protection Rule requires, subject to certain conditions, a marketplace to route orders to another marketplace where there is a better price and often, in effect, overrides considerations of best execution. This creates frustration for the intermediaries and their investor clients because they may be forced into more complex and costly trade execution strategies when new services or trading facilities are introduced. The frustration and additional costs caused by lack of choice for market participants has lead to active resistance to changes. This resistance often takes the form of raising concerns during the regulatory comment process. Resistance may also occur through delays in implementation due to lack of sufficient resources to implement and adapt to the changes.

Christian Voigt noticed similar issues in Europe.30 He states that competition among exchanges was a defining theme in MiFID I, but when it comes to best execution and trading venue fee structure, MiFID II might reverse that. He points out that while exchanges are technically free to innovate on fee structures, firms will find it difficult to justify how rebates or discounts don’t contradict their best execution obligations. As a result new fee models will be hard to support. Requirements: Investor Protection. The securities regulators’ mandate is (a) to provide protection to investors from unfair, improper or fraudulent practices; and (b) to foster fair and efficient capital markets and confidence in those markets.31 Balancing those factors is a key part of what the regulators must do when they review stock exchanges; however sometimes there seems to be an imbalance where emphasis is placed over one part of the mandate. Currently the weight seems to be on investor protection. It also seems that investor protection is seen as avoiding risks.

Investor protection was achieved in the past through transparency, or disclosure and mitigating opportunities for fraud and inappropriate conflicts. For example, the prospectus regime relied

28 Best Execution (Part 4 of NI 23-101) requires a dealer to make efforts to achieve the most advantageous execution terms reasonably available under the circumstances. The Order Protection Rule (Part 6 of NI 23-101) requires, subject to certain conditions, a marketplace to route orders to another marketplace where there is a better price. 29 As a result, when a client cares about size or other factors, the trade may be negotiated in the upstairs market, rather than through the trading books. 30 Christian Voight, “Weighing Up Best-Ex and Best Innovation,” (Tabb Forum, October 21, 2016). 31 See OSA S. 1.1 as an example.


on transparency and disclosure. The regulation of dealers focused on dealers’ honesty, solvency and competency.

The underlying assumption was that investors had a responsibility for making decisions and should be proactive in reviewing information available to them and questioning their advisers.

Over time, products and services have become more complex and rules have become more prescriptive as regulators tried to limit harm..

A key part of the debate missing around investor protection is the importance of context. Should investor protection be same whether the product is equity or debt, simple or complex, public versus private markets? Maybe it should also depend on the stage of the innovation. For example, peer to peer lending was allowed to develop in the beginning without much regulatory interference. Regulators started to look at peer to peer lending after it had gained some size and momentum. This also had the advantage of having actual experience and facts to review when considering how to regulate.

In the stock exchange context, innovation should not be stopped because of potential harm. Stock exchanges should be allowed to introduce new products and services. However they should be required to provide the data, when it becomes available, to analyze the impact of material changes. If the evaluation is postponed until after data is available, then stock exchanges will also have to agree to make changes if inappropriate harm has been caused.

Requirements: Public Interest Mandate. The importance of a stock market to a nation’s economy, as well as the regulatory role it plays, has placed it in a special position which was reflected in securities regulation32. In Canada, the Ontario Securities Act had a requirement that the stock exchange could not act contrary to the public interest. This was interpreted to mean that the exchange could not introduce requirements or act in a way that was detrimental to the public interest. While the term “public interest” was not defined, it was usually interpreted to mean that it was prohibited from introducing requirements that enabled fraud, inappropriate conflicts, or other market integrity issues (as opposed to market quality issues such as matching rules). It did not mean that the exchange had to establish that it had chosen the best or preferred solution, only that it did not choose a solution that caused the prohibited harm. Recently regulators have revised the requirement so that stock exchanges must act in the public interest. Applying this principle is a challenge that has lead the regulators to act more prescriptively and to cause the stock exchanges to be seen and treated as quasi-public entities. Moreover this move to add public interest responsibilities came at a time when the stock exchanges had moved from a not-for-profit to a for-profit commercial model. Stock exchanges

32 Arguably that position is less justified where there are multiple stock exchanges and trading venues, so that the public markets are not dependent upon only one stock exchange.


are commercial entities that not only compete with other stock exchanges, but also with other non-regulated entities such as data vendors and order routers. Thus there was created a disconnect between the exchange’s objectives and the regulators’. It has also caused a serious issue in distinguishing whether an activity is a commercial activity or a regulatory one. For example, it has been hard to separate out the commercial issues when considering market data issues.

Recommendation:

The regulatory process and current requirements for exchanges should allow for experimentation by relying more on oversight and after the fact reviews.

Interpretations of the investor protection and public interest mandate for exchanges should not make them quasi-governmental entities instead of commercial entities. The focus should be on market integrity issues and not market quality issues.

4. Conclusions

In order to maintain competitive industries, the innovation ecosystem must be encouraged and nurtured. Some elements are easier to influence than others. For example, changing regulatory rules, while not easy, is easier to change than changing culture to embrace risk. Allowing incentives can mitigate risk and change behavior. Promoting open access platforms and staged implementation of changes can address some of the costs and issues around adoption. Stock exchanges should be treated mainly as a commercial entity and allowed to compete on services and costs by providing different solutions.

Stock Exchanges and Innovation

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Transcript of Stock Exchanges and Innovation