Dear Readers,
There are many great things about being Canadian. Sadly, being an investor isn't one of them. Not anymore.
Last week, we revealed the shocking truths of high frequency trading (HFT). I saw some great comments and discussions from you guys and very thankful for your contributions.
This week, I am going shed some light on why the TSX Venture is failing.
Most of you probably invested in a company listed on the commodities-focused TSX Venture within the last year, which means most of you probably lost some money.
On a year-over-year basis, the TSX Venture is down 30%, trading volume down around 25%, and transactions are down more than 45%.
While the commodities and precious metals market have slumped due to falling prices and rising costs, many of the companies that have fallen have not dropped because of core fundamentals.
The TSX Venture as a whole has succumbed to more than just a down-dip in metal prices or the rises in costs of production and exploration. This letter is intended to address some of the issues that have led to the crash of the TSX Venture.
These issues include how the big banks are forcing juniors out of the market, just like they have in the US, and also how one regulation has turned into a death spiral event leading to other regulations that collectively are crushing our Canadian market.
Once you read this, please share your thoughts with every one by leaving a comment here:
It's important that Canadians know what is really going on.
Transparency in Trades
The biggest and most important aspect of any stock-trading platform is transparency.
Investors should be able to see exactly how many bids and sell orders are available for a stock at any given time - especially for an exchange that has minimal liquidity and therefore much easier to manipulate. This is how investors calculate at what price he/she should place a buy or sell order.
The depth of the market can be seen using a paid service called Level II that gives you access to the order book in real time. I have always said that anyone who trades should pay for such a service. However, even with this service, you're far from being protected.
Especially since regulators decided to enforce what they believe to be fair competition on the TSX and TSX Venture...
Multiple Trading Platforms
Many retail investors I speak with have no clue that there are multiple parallel trading platforms for the stocks they buy in Canada.
Canadian regulators forced the TMX Group, the parent of the TSX and TSX Venture exchanges, to allow trading through alternative trading systems operated by third parties because they felt there should be fair competition in the market of buying and selling stock in Canada.
As a result, there are now many alternative market centers that process trades for stocks listed on the TSX and TSX Venture. Some of these include Alpha Trading Systems, Chi-X Canada, Pure Trading, Omega ATS, and dark pool Match Now.
According to Stockwatch:
"Alternative trading systems in Canada handled 33.7 per cent of trading volume during the week ended May 3, 2013.
...The Toronto Stock Exchange and the TSX Venture Exchange handled the other 66.3 per cent.
...Looking at securities listed only on the TSX, the exchange captured 61.2 per cent of volume. Chi-X handled 18.3 per cent, Alpha had 11.7 per cent and together the other ATSs handled the rest, 8.8 per cent."
As you can see, these alternative trading systems handle a large portion of the trading volume in Canada, yet most regular Canadian investors don't see this because most quote systems do not include transactions from all of these different platforms.
Furthermore, while volume of trade can be seen by the select few quote platforms that incorporate the volume between these exchanges, none of them combine them in the same bid/ask level II depth because they are being traded on different platforms via parallel order books.
In other words, while you may be trading a stock on one platform, that same stock is being traded on different platforms at the exact same time. This not only removes transparency - especially for the average retail investors - but it also removes visible liquidity for any particular stock.
The retail investor using their online trading quote system doesn't stand a chance - especially when playing on a exchange with little volume, such as the TSX Venture.
But if parallel order books is such an issue, why is it allowed?
Fair Competition
Canadian regulators often do too much in order to solve problems where none exists. Their job is to protect investors but sometimes their actions have repercussions that actually end up doing the opposite.
Regulators believed they were doing the right thing in the spirit of fair competition by forcing the TMX to accept alternative trading platforms.
However, not only did this cause transparency issues for investors, but it also created a domino effect of other problems that regulators tried to combat with other regulatory amendments.
The October 4, 2012 Notice
On October 4, 2012, the TMX Group sent notice to confirm "trading enhancements," set to begin on October 15, 2012.
The enhancements in the notice reflected recent regulatory amendments respecting short sale regulation, the introduction of a short marking exempt designation, amendments respecting dark liquidity on Canadian equity marketplaces, and functionality introduced as a result of client demand and market quality initiatives.
When you try to fight one problem with another problem, the result is never positive. I will explain what's happened in a bit. But first, take a look at the one year chart for the TSX Venture Composite since the rules were announced:
It doesn't take a rocket scientist to breakdown this chart.
Since the notice of the "Trading Enhancements Update" by the TMX, the TSX Venture has dropped like a rock.
Why?
The Death Spiral
When regulators forced the TMX Group to allow trading through alternative trading systems operated by third parties, it caused real time transparency issues.
When you combine the lack of transparency in parallel trading platforms with the use of High Frequency Trading (discussed last week), regulators had no choice but to eliminate the tick test rule, or uptick rule, for short selling.
Let me explain.
Discontinuing Price Restrictions of Short Sell Orders (Tick Test)
Historically, you could only sell a stock short if the price is higher than the last different price; simply put, you can only short a stock as it was moving up.
However, this rule only works when there is a strict sequence of orders in the order execution book; when bid/ask orders are placed in line on a first-come first-serve basis. But with parallel trading systems, a definitive sequence of different prices can't be established at any exact given point in time because one order book might show a down-tick, while the other an uptick.
As a result, it would be extremely difficult to enforce the uptick rule
By allowing competing trading platforms and to encourage HFT (which was believed to create more liquidity), regulators had no choice but to remove the tick test rule. In the October 4th announcement, the rule was eliminated:
"TSX, TSX Venture Exchange (TSXV) and TMX Select will no longer constrain short sell orders to the last sale price. Short sell orders entered will be permitted to trade down to their limit price establishing a last sale price on a down tick. Short Crosses will no longer be constrained by the last sale price."
That means we can now short a stock anytime we want. That's great news for shorters, but for companies trying to raise money at higher prices to hire more staff or move their projects forward, that rule can cripple them - especially under the liquidity constraints of the Canadian market.
It doesn't take a lot of money to control a stock via short selling on the TSX Venture. As a matter of fact, institutions often hammer stocks via short selling and back up their shorts with warrants they obtained in a previous financing.They often force the price of a stock down to finance the same companies they're shorting to get a better financing price; or to force a company into a financing arrangement.
Short selling isn't the only thing destroying the TSX Venture. Another rule change is hurting the market and its one you would never expect.
Dark Pool Liquidity
Hate it or love it, dark pools represent a lot of available liquidity for many institutions - especially independent brokerage houses. Here is a quick video explaining dark pools:
While retail investors rarely participate in this type of trading, there are often benefits to the use of these dark pools in Canada via volume of trade.
Dark Pools is trading volume or liquidity that is not openly available to the public. Dark liquidity pools offer institutional investors many of the efficiencies associated with trading on the exchanges' public limit order books but without showing their actions to others. Dark liquidity pools avoid this risk because neither the price nor the identity of the trading company is displayed.
There are many advantages to dark pools, especially on the Canadian market.
One of the main advantages for institutional investors in using dark pools is for buying or selling large blocks of securities without showing their hand to others and thus avoiding market impact as neither the size of the trade nor the identity are revealed until the trade is filled.
During a market decline, dark pools can help facilitate big sell orders from fund redemption without having to smash the open market and cause stocks to crash.
Dark pools can also be posted inside the existing limit order book alongside public liquidity, usually through the use of iceberg orders.
Iceberg Orders
Iceberg orders are orders that appear to be small but in reality are much bigger.
The order is queued along with other orders but only the display quantity is printed to the market depth.
When the order reaches the front of its price queue, only the display quantity is filled before the order is automatically put at the back of the queue and must wait for its next chance to get a fill. While not exactly dark, iceberg orders have an advantage of not showing the full sell size of an order to avoid scaring market participants. It can also do the same for buy orders for those that want to purchase more stock without running up the price.
While it may seem unfair that trades exists outside of the public realm during trading hours, trades executed in dark pools are incorporated into a post-trade transparency which means investors do have access to them.
This can aid price discovery because institutional investors who are reluctant to tip their hands in lit market still have to trade and thus a dark pool with post-trade transparency improves price discovery by increasing the amount of trading taking place.
In other words, volume of trade increases. For the Canadian market, that's a much-needed thing.
New Rules that Affect Dark Orders
On October, the Investment Industry Regulatory Organization of Canada and the Canadian Securities Administrators introduced rules that give lit orders priority over dark orders in the same venue.
Smaller dark orders will now have to offer significant price improvement. Orders under 5,000 shares or C$100,000 dollars in value must offer at least half a tick in price improvement for stocks that have a spread of one tick spread, and a full tick of price improvement for stocks with higher spreads.
While regulators are trying make the market more transparent, industry insiders say the rules will reduce passive liquidity in dark pools and cause routing issues, as dark orders can only execute after all lit market options have been exhausted.
Canadian dark pool Match Now's parent ITG expects inter-listed equities trading in Canada to drop by 5% as the dark pools route the flow of trade into the US as a result of the new rules:
"We'll definitely see inter-listed stocks trade more in the US than in Canada because of this rule. Dealers can automatically route inter-listed trades to both US and Canadian venues, so there's no technological barrier to instantly routing these trades." - Doug Clark, managing director of research for ITG.
Here is yet another situation where a rule, meant to make the market better, is actually making it worse. Having to hunt for liquidity across all displayed markets before sending an order to a dark pool causes unnecessary confusion:
"There will be many situations when a buyer and a seller can't interact because of the way routing works around this rule because they create technical issues regulators don't understand," Clark said, adding that smaller and mid-sized dealers will struggle to adjust trading strategies, while institutional traders may eventually find a technology work-around to the routing issues.
Again, the smaller guys fail and the bigger banks win.
The October Rules Plague
Dark trading in Canada hit a record high of 5.87% of total trading volume last August.
Dan Kessous, CEO of Chi-X Canada, fears the regulation will limit the use of dark trading, adversely affecting the market:
"There will be less resting liquidity so there will be lower volumes overall, and it will probably get worse over time as people realise they have to change their trading strategies."
Were his fears warranted?
Here's the same TSX Venture chart from before, but this time highlighting the record high dark trading month, just before the dark pool rules announcement:
In August, the stock market was rising despite being in the summer doldrums that the TSX Venture is commonly known for. While there is no proven correlation between the Venture's rise in August and dark pool trading, there's no doubt that the TSX Venture was rising during a month when dark pool trading was at its highest.
Since October, much of the volume in Canada has been routed to the US for inter-listed companies. Trading volume for inter-listed companies are now much higher on the US exchanges for the majority of the inter-listed companies based in Canada.
The TSX Venture volume is down more than 25% year-over year as of April, and transactions down nearly 45%.
Are the new rules making investing better for us?
The End Game
Pointing the finger is a pointless act. However, we do need to address the issues of what new rules are doing to our investments in this market.
Is the mood that somber in the commodities market, or are the new regulations adding too much fuel to a fire that should have been much smaller?
As I always say, I am not here to accuse or point fingers, but rather show you some facts and let you make the decision yourself.
This downturn has forced both investors and smaller institutions out of the market, leaving room only for the big boys to play.
The Canadian investment market is being changed to reflect large institutional firms that are only looking for yield products. Independent brokerage firms are drying up because funding for junior projects are drying up as investors have lost too much money to want to play again.
Much of the money remaining is now being filtered to bigger banks and bigger companies.
Juniors on the TSX Venture really don't stand a chance.
For the average junior, it costs on average around $200,000 just to maintain their listing and legal fees to keep up with regulators. That means a small junior who just raised a million dollars, will need to take 20 cents out of every dollar to comply with security regulations.
It's no wonder why analysts are predicting that at least 500 companies on the Venture will run out of money before the year is over. Many of these companies have less than $250,000 in the bank. Considering that it takes around $200,000 a year just to comply with regulations, there is a great chance that the analysts are right.
All of this is leading to the demise of the TSX Venture if things don't change. All over the country, there are town hall meetings to address the issues. But who's listening?
I believe the market needs strong regulation to prevent scumbags from operating and stealing investor money. But over regulation, and creating regulations that stops the market from moving forward, only loses money for investors and prevents companies from moving forward, innovating, and creating jobs.
Regulators need to be prosecuting those who are clearly ripping people off, and those who are clearly involved in manipulation. The biggest problem is that the biggest manipulators are likely to be the biggest banks with the biggest resources.
Manipulation on the Canadian Market
I have witnessed trades for many stocks where you can clearly see the manipulative efforts of small block sell orders coming through, that appear to be intentionally forcing share price down. Those with real-time Level II will be able to see this activity all day long. Much of this activity runs through the houses of Canada's biggest banks, and it almost always forces the price of stocks down to a point where liquidity and buy orders have completely dried up and there is no more stock floating around in the system to short.
With the removal of the uptick rule, firms are now shorting at will and destroying companies for small profits. Institutions have many advantages that we don't. They can short stock and have a fairly lengthy period before they have to replace that stock, should their shorts need to be covered. Even if their shorts need to be covered in a short time frame, they can extend that time frame by borrowing stock owned by their clients.
Too big too fail is sadly a very real scenario. As smaller institutions dry up, investors will transfer over to the bigger guys who will then control more money.
Considering that more than 50% of the world's financing for resource projects stems from Canada, with a third coming form the TSX and the Venture, the resource sector is not looking very bright.
But don't think its over. Not for one second.
Foreign Equity Opportunity
Companies are having extreme troubles funding through public vehicles because that money has dried up due to over manipulation and regulation (for now.) But that doesn't mean capital isn't available.
As a matter of fact, capital is abundant - especially in foreign countries.
Private equity is growing and foreign capital is looking for a place to call home. Foreign investors not only have an abundant wealth of capital, but they're looking to deploy it.
I know this because I work with a few very smart individuals to help fund good projects through strategic, private equity, sovereign wealth fund and state-owned enterprise buyers.
Please don't hesitate to send me information if you're a company that needs help.
Companies who are smart and have great assets should start looking elsewhere for money.
