The Impact of Message Traffic Regulatory Restrictions on Market Quality: Evidence from Chi-X Canada

Andrew Leponea, Alexander Saccoa

a

Discipline of Finance, University of Sydney, N.S.W., 2006 Australia

Abstract The contemporary growth in Algorithmic Trading (AT) has occurred in a dynamic financial market, realized through the active relation between regulatory development, firm and market competition, as well as significant technological changes. Despite recent empirical research suggesting a positive relation between AT and improvements to market quality, several market participants still question the tangible benefits of AT. Recently several market regulatory bodies have proposed or implemented cost recovery and fee models that charge brokers for market participation on a pro rata basis with respect to message traffic and trading activity. Findings suggest that high order-to-trade ratio trading strategies, often characterized as HFT, are linked to improvements in spread and depth measures of liquidity on Chi-X Canada. Furthermore, the implementation of IIROCs Integrated Fee Model on April 1, 2012 has coincided with a decline in quote submission, trades, volume, and deterioration of liquidity. The relation between order-to-trade measures, that proxy for AT, and liquidity measures deteriorates following the implementation of the IIROC 2012 Integrated Fee Model. Keywords: Algorithmic Trading; High Frequency Trading; Liquidity; Market Microstructure JEL Classification: G10

INTRODUCTION Recent research generally suggests a relation between high quote message traffic and trading activity, and improving market quality; increasing liquidity, price discovery, and reduced volatility (Hendershott, Jones, and Menkveld, 2011; Hasbrouck and Saar, 2010; Brogaard, 2012). Academic studies, including Hendershott, Jones, and Menkveld (2011), and a range of market participants attribute this high quote message traffic and trading activity to the recent increased incidence of Algorithmic Trading (AT) and High Frequency Trading (HFT). Some market participants, nonetheless, remain skeptical of the advantages of trading in a market that has prevalent AT and HFT, for fear of their perceived speed and informational advantage, and propensity to exasperate volatility (CESR 2010a, 2010b; Easley, Lopez de Prado, and OHara 2011; European Parliament, 2010). This paper examines the association between high order-to-trade (OTT) ratio trading strategies; commonly used as a proxy for AT, and broader liquidity based market quality metrics for the ATS Chi-X Canada. Using the implementation of Investment Industry Regulatory Organization of Canadas (IIROC) Integrated Fee Model on the 1 April 2012, this study is able to examine the impact of regulators fee models that are allocated pro rata with respect to participants quote message traffic and trading strategies, on quote message traffic, trading strategies, and market quality. To establish causality this study incorporates this important exogenous event that is expected to decrease the amount of message traffic and trading activities in stocks on Chi-X Canada.

IIROC implemented the Integrated Fee Model on April 1, 2012, which involved a fee model that allocates IIROCs annual operating cost to two pools comprising of unique costs for each of Dealer and Market regulation. Of particular interest to this study is the Market Regulation Fee Model; IIROC is one of the first financial regulators globally, along with ASIC (Australia), to propose and implement a fee structure to recover market regulatory costs based on participants message traffic and trading activity. IIROC estimates that approximately 85% of firms will see a decrease based on the new market regulation model, while 15% of firms will experience a fee increase (IIROC, 2012). The 15% that are expected to experience a fee increase are firms that contribute a greater number of message traffic and trading activity, that is, HFT firms. This study is motivated to examine the impact of pro rata message traffic and trading activity cost recovery measures of trading activity and market quality. HFT is a subset of AT; which is commonly defined as the use of computer algorithms to automatically make certain trading decisions, submit orders, and manage those orders after submission (Hendershott, Jones, and Menkveld 2011). High Frequency Traders (HFTrs) are characterized by IIROC (2012) as having an order submission-to-trade ratio of greater than 3, with more than 1000 daily trades. Whilst HFT is a subset of AT, not all forms of AT can be attributed to HFTrs. For instance, the SEC (2010) characterizes proprietary firms engaged in HFT as: (1) the use of extraordinarily high-speed and sophisticated computer programs for generating, routing, and executing orders; (2) use of colocation services and individual data feeds offered by exchanges and others to minimize network and other types of latencies; (3) very short time-frames for establishing and liquidating positions; (4) the submission of numerous orders that are cancelled shortly after submission; and (5) ending the trading day in as close to a flat position as possible.

It follows that restrictions being placed on firms that employ higher OTT ratio strategies, that have been shown in empirical studies to improve market quality, can be expected to detract from market quality measures on the specifically regulated market. This study uses raw measures of message traffic, trades, and OTT ratio to examine the association between message traffic and trading and liquidity. Furthermore, following Hendershott, Jones, and Menkveld (2011) a normalized measure of Chi-X Canada electronic message traffic (submissions, amendments, and cancellations) and trades is used as a proxy for AT activity. This measure offers a proxy for variation in algorithmic liquidity supply associated with limit order submission strategies. Because the IIROC 2012 Integrated Fee Model is a pro rata structure based on message traffic and trades, rather than the message traffic scaled by trading volume as is the case with Hendershott, Jones, and Menkvelds (2011) proxy, the OTT ratio will measure the association between message traffic, trading, activity and liquidity with respect to the IIROC 2012 Integrated Fee Model. This study employs regression analysis to examine the relation between OTT ratio and market quality using a sample of top 60 stocks (market cap) for Chi-X Canada (1/01/2011 to 1/08/2012). This sample period covers the phase-in of IIROC 2012 Integrated Fee Model (1 April 2012), an exogenous event that is expected to decrease the amount of message traffic and trades in stocks on Chi-X Canada. Results suggest that an increase in OTT is associated with a decrease in quoted and effective spreads and an increase in depth for the sample of 60 stocks. When segmenting the stocks into market capitalization quartiles, stocks with lower market capitalization and liquidity exhibit a strong relation between OTT and spread based liquidity measures. Contrastingly, larger market capitalization firms exhibit a stronger positive statistically significant relation with depth. Analysis of this relation with respect to quartiles sorted by message traffic, and trading activity

reveals that stocks with lower message traffic exhibit a strong relation between improvements in spread based liquidity measures and heightened OTT ratio measure. Stocks with a higher amount of message traffic exhibit a positive and statistically significant relation between depth and OTT while stocks with a lower amount of message traffic exhibit a negative and statistically significant relation. Results for quartiles based on trading activity suggest that for stocks that have higher trading activity the relation between the OTT ratio measure and spread based liquidity measures is weaker than for stocks that have lower trading activity, while for depth stocks with higher trading activity exhibit a stronger relation between depth and OTT. Further analysis reveals that the implementation of the IIROC 2012 Integrated Fee Model results in a statistically significant decline in message traffic, trading volume ($), the OTT ratio measure, the AT proxy, and liquidity measures. Furthermore, panel data regression analysis reveals a deterioration in the relation between AT, and High OTT strategies and market quality following the introduction of the Integrated Fee Model. These results indicate that high OTT trading strategies, often characterized as HFT, are associated with improvements to market quality and regulatory restrictions targeting such trading activities adversely impact market quality. This paper proceeds as follows. Section I discusses related literature. Section II describes Chi-X Canada and IIROC 2012 Integrated Fee Model. Section III provides a summary of data and descriptive statistics, including an examination of the studys AT proxies and liquidity measures. Section IV examines the relation between OTT ratio and liquidity on Chi-X Canada. Section V examines the impact of the IIROC 2012 Integrated Fee Model on OTT and liquidity. Section VI concludes.

I. LITERATURE REVIEW Algorithmic trading programs are used to facilitate and execute trades in both agency and proprietary functions and extend to; minimizing execution costs by order splitting into smaller packages, finding price patterns for short-horizon arbitrage opportunities, or market making strategies incorporating High Frequency Trades (HFTs). Hendershott, Jones, and Menkveld (2011) characterizes AT as liquidity suppliers that have a dynamically manage their orders, and thus measures AT activity via a proxy based on a normalized message traffic to trade ratio. Given the importance of automated, high OTT ratio traders in financial markets, there is a growing body of literature which examines the relationship between AT and market microstructure. These studies seek to examine whether the growth in computerized trading has had a positive effect on market quality or has detracted from it. Cvitanic and Kirilenko (2010) build the first theoretical model to address how HFTrs affect market conditions. They model an electronic market populated by low frequency traders (humans) and add a high frequency trader (machine). This machine is assumed to be uninformed, akin to a market maker. The advantage of the machine relative to a human trader is its higher speed in submitting and cancelling orders. The authors find that the presence of HFTs yield transaction prices that differ from the HFT-free price; when a HFTr is present, the distribution of transaction prices will have thinner tails and are concentrated near the mean. The implication is that the presence of HFTs results in an increase in liquidity. Jovanovic and Menkveld (2010) develop a theoretical model of algorithmic traders as market makers in electronic limit order markets, and assess the effect this role has on investor welfare. In limit-order markets without middlemen, newly placed limit orders are either matched

with existing limit orders or are added to the order book. They surmise that as AT is the use of computer algorithms to analyze market data and make trades, the introduction of algorithmic traders to a limit order market may reduce information friction if the information between two investor arrivals is hard, machine-processable information. Jovanovic and Menkveld (2010) assess the validity of this model using the natural experiment provided by the introduction of Chi-X to compete with Euronext. The features of Chi-X make it attractive to liquidity supplying AT, as it provides a subsidy to a quote that leads to execution, relative to Euronext who charge a fee for price quote changes. The authors find that entry of an HFT to the market was accompanied by a 23% reduction in adverse selection costs and a 17% increase in trade frequency. Employing a unique dataset from Nasdaq OMX that distinguishes between HFT and non HFT trades, Brogaard (2010) analyses the impact of HFTs on market quality, focusing on liquidity, price discovery and volatility. The author finds that HFTs makes up a large majority of trades, supplying and demanding liquidity for approximately half of all trades. Their activities in supplying and demanding liquidity are stable over the sample period. Results indicate that HFTs demand liquidity at smaller order sizes and that trades surrounding a demanded HFT execute faster than a non-HFT. Price discovery improves, with Brogaard (2010) showing that HFTs provide comparatively more useful information to the price discovery process. Analyzing the component stocks of the Russell 1000 and Russell 200 Index, Castura, Litzenberger and Gorelick (2010) provide evidence that several aspects of market quality for U.S. equity markets has improved as the ratio of AT to total market activity has grown. The results

show that bid-ask spreads have narrowed and market depth has increased over time for a broad range of stocks, coinciding with automation on exchanges. Hendershott, Jones and Menkveld (2011) investigate the impact of AT on market quality on the NYSE by using a normalized measure of electronic message traffic as a proxy for algorithmic liquidity supply. Using panel-regressions over 5-years following decimalization in 2001, the authors find that AT and liquidity are positively related. To examine causality, the implementation of auto-quoting on the NYSE is treated as an exogenous instrument for AT. Results indicate that AT improves quoted and effective spreads, but reduces market depth. The degree of price discovery that is correlated with trading is shown to decrease after the introduction of autoquote, indicating that algorithms respond quickly to order flow information and reduce adverse selection in the market. The authors interpret these results as indicating that AT causally improves liquidity. Employing two proprietary datasets from Chi-X and Euronext, that contain anonymized broker IDs for trades in Dutch index stocks, Menkveld (2012) examines the impact of an HFT trader on these two markets. The author identifies a trader that enters both markets simultaneously, who fits the profile of an HFT. The trader has an upper bound latency of 1.67 milliseconds, engages in proprietary trading, generates a high number of trades, and finishes the trading day with a net zero inventory position. Menkveld (2012) notes that the entry of the HFT trader coincided with a 50% fall in the bid-ask spread. The activities of the HFTrs show it acts primarily as a multi-venue market maker. The HFTrs contributed to liquidity across both markets, supplying liquidity 80% of the time.

Hasbrouck and Saar (2010) analyze trading activity in the millisecond environment. Using Nasdaq order-level data, every order entry including submission, cancellation and execution of an order are time-stamped to the nearest millisecond. They find that the millisecond environment is characterized by two sets of traders; traders who operate according to a schedule (e.g. trading orders in smaller trade sizes), and traders that respond to market events. The authors construct a measure of low-latency activity by tracking submissions, cancellations and executions, and analyze how this measure affects market quality. Employing a simultaneous equation framework, the authors find that a decline in latency is associated with tighter quoted spreads, increased depth, reduced price impact and lower volatility. Furthermore, Hagstrmer and Nordn (2012) distinguish between market making HFTrs and opportunistic HFTrs (arbitrage and momentum HFT strategies) on NASDAQ OMX Stockholm and we find that market makers constitute the majority of HFT trading volume (63-72%) and limit order traffic (81-86%). They characterize market makers as having higher order-to-trade ratios, lower latency, lower inventory, and supply liquidity more often than opportunistic HFTs. Hagstrmer and Nordn (2012) recommend that the financial transaction tax proposed by the European Commission, which would render most HFT strategies unprofitable, would primarily hit market makers and adversely impact market quality.

II. INSTITUTIONAL DETAILS A. Chi-X Canada Chi-X Canada, launched on February 20 2008, is an ATS providing registered dealers with fully automated order matching and execution of trades in Toronto Stock Exchange (TSX) listed equities. Chi-X Canada offers price/time priority, post-trade attribution, market-agnostic smart

routing, advanced order types, trade reporting, risk management tools, historical market data, co-location and cross connectivity services (Chi-X Canada, 2012). Order price and volume information is available, while orders and trades are anonymous. Chi-X Canada operates from 8:30 am to 5:00 pm ET, and does not participate in opening or closing call auctions. On market trading occurs between 9:30am and 4pm. The market, which is one of the largest ATS platforms in Canada, holds 9.9 15.6% average TSX listed monthly volume market share in the Canadian Marketplace over the sample period.

B. IIROC 2012 Integrated Fee Model IIROC is the national self-regulatory organization that oversees all investment dealers and trading activity on debt and equity marketplaces in Canada. IIROC implemented the Integrated Fee Model on April 1, 2012, which involves a fee model allocating IIROCs annual operating cost to two individual pools comprising of costs for each of Dealer and Market regulation. The Market Regulation Fee Model is of particular interest to this study; IIROC is one of the first financial regulators globally, along with ASIC (Australia), to propose and implement recovering technology costs based on message traffic and trading activity. As Canadas national self-regulatory investment organization IIROC determines their total market regulation costs and then deducts the disclosure fees and other income received. The net costs are then allocated to each marketplace member on a pro rata basis and are paid by that marketplaces participating organizations, members, or subscribers identified by the Marketplace and based on the number of electronic

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messages sent and trades executed by each Dealer member on each marketplace1 in accordance with the provisions set out below; A fee calculated for each marketplace based on that marketplaces share of the total number of messages processed by IIROCs surveillance system during the month this component recovers the IT costs of the surveillance system. A fee calculated for each marketplace based on that marketplaces share of the total number of trades during the month this component recovers all other regulation costs. The number of trades by a market maker in its stock of responsibility on an exchange will be discounted by 70% for the purpose of calculating the fee based on that exchanges share of the total number of trades. The number of trades on the other side of any trade involving a market maker in its stock of responsibility will be included in the calculation of the overall total number of trades for an exchange. Similarly, ASIC (2012) reports that market supervision and competition cost recovery regime, implemented on 1 January 2012, provides an avenue for the Australian Government to recover the funding that it approved in 200910 and 201011 to cover ASICs additional costs for, undertaking its new regulatory functions following the transfer of market supervision (on 1 August 2010) and the introduction of market competition (in equity securities) via Chi-X Australia, and the development of a framework to support market competition (ASIC, 2012).

If the aggregate of the Message Processing Fee and the Trade Volume Fee allocated to a Marketplace Member is less than $4,800 in a particular month, such Marketplace Member shall be allocated the Minimum Market Regulation Fee of $4,800

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During the 18 months from 1 January 2012 to 30 June 2013, ASICs additional supervisory costs in relation to the participants of the Australian Securities Exchange (ASX) and Chi-X cash equities markets (for equity securities), including the deferred costs associated with implementing market competition, are $22.81 million (ASIC, 2012) proportionally allocated to each participant as follows; non-IT costs ($14.92 million) will be proportionally allocated based on the number of transactions, and IT costs ($7.89 million) will be proportionally allocated based on the scale of message traffic. Criticisms of the fee models from IIROC and ASIC center on an apparent bias against HFTs, and high message traffic (OTT ratio) trading strategies. Hendershott, Jones, and Menkveld (2011) indicate that AT has a considerably higher order submission and trade proportion and offer a meaningful contribution to market quality. They argue that for cost and latency reasons, AT generally do not rely on human intermediaries but instead frequently and systematically generate order submissions, amendments, and cancellations that are sent electronically to a trading venue. They use the rate of electronic message traffic as a proxy for the amount of AT taking place, and find a positive relation between this measure and market quality. Further, Hagstrmer and Nordn (2012) find that the high order-to-trade ratios associated with HFT is primarily a market-making phenomenon. They conclude that policies directed toward reducing order-to-trade ratios and imposing minimum limit order durations, which has been considered by both the European Commission (2010) and German authorities, are likely to limit market makers ability to adapt to news in a fragmented market. They surmise that this would increase the adverse selection cost to market makers, leading to wider bid-ask spreads and lower depth.

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III. DATA AND DESCRIPTIVE STATISTICS Data are sourced from Thomson Reuters Tick History (TRTH) via the Securities Industry Research Centre of Asia-Pacific (SIRCA). The data set consists of trade-by-trade data for the top 60 market capitalized, continuously listed shares on Chi-X Canada from 1 January, 2011 to 1 August, 2012. The trade dataset is combined with 1st level order book data sourced from Thomson Reuters Tick History (TRTH). Each line of order book data represents order submissions, amendments, and cancellations at the best bid or ask. This complete dataset provide a reconstruction of the full order book for each trade for on-market trading. For each trade, the following information is provided in the dataset: (i) the direction of the trade (i.e. buy/sell), (ii) the share volume, (iii) stock code, (iv) date, (v) timestamp to the nearest millionth of a second, (vi) and (vii) best bid and ask prices and share volume. Table I presents descriptive statistics for the entire sample of 60 stocks, as well as market capitalization quartiles. For the entire sample the average number of trades and message traffic per stock per day is 2259 and 70398 respectively, while the average OTT ratio measure per stock per day is 50.043. The average on market volume is 323096 with a total trade value of $9775055.43. When considering market capitalization quartiles, the larger market cap firms have higher mean trades and message traffic with 3257 and 105551 respectively in quartile 1 declining to 942 and 28981 respectively in quartile 4. The OTT and ALGO measure increase from Quartile 1 to 4 suggesting that message traffic in higher market capitalization firms attracts pro rata, a higher number of trades. When considering liquidity measures; effective and quoted spread, and depth the overall sample has a mean effective (quoted) spread of

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4.63 (10.71) bp and depth of 36947. Effective spreads increase from 1.89 bp in quartile 1 to 8.46 bp in quartile 4, while quoted spreads exhibit a similar relation increasing from 4.35bp to 19.63 bp from quartiles 1 to 4. Depth declines from 44545 to 28440 from quartiles 1 to 4. In the sample the higher market-cap stocks typically exhibit higher levels of liquidity; tighter spreads and greater depth.
Table I Q Mean Median ALL ALL Trades 2259 1767 1990 3257 2733 2294 2753 2378 1948 2085 1735 1692 942 650 963 Market Cap ($) 19577824837 12073263804 16674622349 43320210816 37699801112 15338908573 18546529610 Message Traffic 70398 52333 64762 105551 83886 77274 79134 61879 61749 67927 55904 55423 28981 21390 29811 Share Turnover (%) 0.056527 0.046639 0.051699 0.043619 0.039153 0.024778 0.059018 OTT 50.043 29.808 135.987 38.883 30.879 36.316 40.123 26.109 43.505 43.087 30.570 41.588 78.079 32.622 260.73 Volatility 0.023386 0.019727 0.014641 0.019406 0.016675 0.011212 0.025303 ALGO 0.010338 0.007315 0.021396 0.006172 0.005267 0.004029 0.0088 0.007312 0.006044 0.010565 0.008917 0.007185 0.015813 0.008962 0.040954 Effective Spread (bp) 4.63442 2.67805 8.11896 1.89065 1.55591 2.52582 3.30648 Volume 323096 210900 389189 399551 324700 302853 415161 297800 383093 289735 205700 407220 187936 74450 409792 Quoted Spread (bp) 10.70865 6.15323 18.59013 4.3489 3.57376 5.37299 7.5767 Trade Value ($) 9775055.43 6955776.21 10164885.85 18584049.96 16192050.75 11651858.87 10199337.82 8596788.5 6844528.55 7342753.74 6168364.25 9680294.29 2974080.22 2414602.25 2657110.87 Best Depth 36947 28349 61117 44545 40311 20900 42702

Mean 1 Median Mean 2 Median

Mean 3 Median

Mean 4 Median

Mean Median

Mean 1 Median 2 Mean

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Median

Mean 3 Median

Mean 4 Median

17253049794 6299838799 10161111985 10038636946 1810014415 6283446938 6045075128 1935746188

0.051006 0.041947 0.072217 0.062256 0.076291 0.051254 0.041231 0.045298

0.021605 0.015307 0.026959 0.023195 0.016558 0.021877 0.018221 0.013741

2.5133 3.87434 4.88537 2.99686 8.64881 8.45517 4.59001 11.9814

5.79045 8.87562 11.27827 6.93161 19.67688 19.63073 10.51589 27.52297

34263 26801 32100 24346 74505 28440 17906 89724

Table I Descriptive Statistics This table presents descriptive statistics for the data set consisting of trade-by-trade and quote level data for the top 60 market capitalized, continuously listed shares on Chi-X Canada from 1 January, 2011 to 1 August, 2012, which covers the phase-in of IIROC 2012 Integrated Fee Model (1 April 2012). The data is sorted into quartiles where quartile 1 contains largest-cap stocks.

A. Message Traffic and Trading Measures This study employs four metrics to examine order submission and trading activity, and subsequently the market quality impact of cost recovery and fee models that charge brokers for market participation on a pro rata basis with respect to message traffic and trading activity. Furthermore, the rate of electronic message traffic is used as a proxy for the amount of automated trading taking place across stocks and days. This proxy is commonly used by market participants and in academic studies, including Capital Markets CRC Ltd, Hendershott, Jones, and Menkveld (2011), the Tabb Group, as well as exchanges and alternative trading platforms. With respect to the TRTH SIRCA Chi-X data electronic message traffic measures order submissions, cancellations and amendments across the best bid and ask (1st level). This study employs the OTT ratio measure as the number of electronic message traffic divided by the

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number of trades. To account for varying trading volume over the sample period this study employs Hendershott, Jones, and Menkvelds (2011) AT proxy that employs normalization of the raw message traffic measure by $ trading volume (price * volume) as a robustness test. . Because the IIROC 2012 Integrated Fee Model is a pro rata structure based on message traffic and trades, rather than the message traffic scaled by trading volume as is the case with Hendershott, Jones, and Menkvelds (2011) proxy, the OTT ratio will measure the association between message traffic, trading, activity and liquidity with respect to the IIROC 2012 Integrated Fee Model.

Figure 1 plots average daily stock message traffic by market capitalization quartiles over the 1/1/2011 - 1/8/2012 sample period. The message traffic measure is fairly volatile, but increases across the quartiles from the start of the sample period to the end of 2011. The sample appears to stabilize across the quartiles following 1 April 2012 coinciding with the introduction of IIROC 2012 Integrated Fee Model. All four series; Q1 Q4 appear to be strongly correlated, however the decline in the later part of the sample period if most noticeably experienced by Q1, 2, and 3.

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4500000 4000000 3500000 3000000 2500000 2000000 1500000 1000000 500000 1/01/2011 1/02/2011 1/03/2011 1/04/2011 1/05/2011 1/06/2011 1/07/2011 1/08/2011 1/09/2011 1/10/2011 1/11/2011 1/12/2011 1/01/2012 1/02/2012 1/03/2012 1/04/2012 1/05/2012 1/06/2012 1/07/2012 1/08/2012 0 Q1 Q2 Q3 Q4

Figure 1. Message Traffic. This figure presents mean daily Message Traffic (submissions, amendments, and cancellations) by stock over the 1/1/2011 - 1/8/2012 sample period. Stocks are segmented into quartiles based on market capitalization.

Figure 2 plots average daily stock trading activity by market capitalization quartiles over the 1/1/2011 - 1/8/2012 sample period. Much like the four series in Figure 1, the trading activity is fairly volatile but increases across the quartiles from the start of the sample period to the end of 2011. The sample appears to stabilize across the quartiles following 1 April 2012 coinciding with the introduction of IIROC 2012 Integrated Fee Model. All four series; Q1 Q4 appear to be strongly correlated, particularly amongst the first three quartiles. When comparing

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Figure 1 and 2, following the introduction of IIROC 2012 Integrated Fee Model, the decline in Message Traffic appears to be greater than the decline in trading activity for the smaller market capitalization quartiles. Figure 3 for Trading Volume ($) suggests a similar trend, particularly in the first quartile.
120000 100000 80000 60000 40000 20000 0 Q1 Q2 Q3 Q4

1/01/2011

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1/03/2012

1/04/2012

1/05/2012

1/06/2012

1/07/2012

Figure 2. Trading Activity. This figure presents mean daily Trading Activity by stock over the 1/1/2011 - 1/8/2012 sample period. Stocks are segmented into quartiles based on market capitalization.

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1/08/2012

600000000 500000000 400000000 300000000 200000000 100000000 0 Q1 Q2 Q3 Q4

1/01/2011

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Figure 3. Trading Value. This figure presents mean daily Trading Value ($) (Price*Volume) by stock over the 1/1/2011 - 1/8/2012 sample period. Stocks are segmented into quartiles based on market capitalization.

Figure 4 plots the average daily stock OTT ratio by market capitalization quartiles over the sample period; that is for an equally weighted portfolio containing the 15 stocks for each of the quartiles. For Q1, Q2, and Q3 there appears to be a drop off in the OTT ratio over the sample period, including the post IIROC Integrated Fee Model sample. This is consistent with the trends in Figures 1 and 2 for message traffic and

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1/08/2012

trading activity. The more volatile and higher OTT trends for Q4 can be attributed to thinner trading activity relative to message traffic. As an additional measure and test, Hendershott, Jones, and Menkvelds (2011) ALGO proxy is plotted in Figure 5. This normalized message traffic measure shows a clearer disbursement between the quartiles, however trends are consistent across quartiles.

250

200

150 Q1 100 Q2 Q3 Q4 50

1/01/2011

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Figure 4. Order-to-trade ratio. This figure presents mean daily order-to-trade ratio by stock over the 1/1/2011 - 1/8/2012 sample period. Stocks are segmented into quartiles based on market capitalization.

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1/08/2012

45 40 35 30 25 20 15 10 5 1/01/2011 1/02/2011 1/03/2011 1/04/2011 1/05/2011 1/06/2011 1/07/2011 1/08/2011 1/09/2011 1/10/2011 1/11/2011 1/12/2011 1/01/2012 1/02/2012 1/03/2012 1/04/2012 1/05/2012 1/06/2012 1/07/2012 1/08/2012 0 Q1 Q2 Q3 Q4

Figure 5. Normalized ALGO measure. This figure presents mean daily normalized order-to-trade ratio (by $1000 Trading Value) by stock over the 1/1/2011 - 1/8/2012 sample period. Stocks are segmented into quartiles based on market capitalization.

B. Market Quality Measures Liquidity is measured using quoted-spreads, effective-spreads, and depth, all of which are measured as equally weighted averages by a simulated share portfolio holding and expressed in basis points as a proportion of the prevailing midpoint (with respect to spreads). The effective spread is the difference between the midpoint of the bid and ask quotes and the actual transaction price, divided by

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midpoint. The wider the effective spread, the less liquid is the stock (Hendershott, Jones, and Menkveld 2011). For the tth trade in stock j, the proportional effective spread, espreadjt, is defined as: qjt(pjt mjt)/mjt where qjt is an indicator variable that equals +1 for buyer-initiated trades and 1 for seller-initiated trades, pjt is the trade price, and mjt is the quote midpoint prevailing at the time of the trade. Quoted spread is simply a measure of the difference between prevailing bid and ask quotes divided by midpoint. Depth is measured as the sum of the prevailing bid (ask) price multiplied by the prevailing bid (ask) size. For each stock each day, this study uses all Chi-X Canada sample trades and quotes to calculate quoted and effective spreads, and depth for each reported transaction and calculate a stock-weighted average across all trades that day. Figures 6 and 7 plot the quoted and effective spreads over the sample period. The quoted and effective spreads for each of the quartiles are strongly correlated, with a fairly consistent increase for each of the quartiles following 1 April 2012. The spikes between 1 August 2011 and 1 January 2012 are examined and positively correlate to measures of volatility over the corresponding periods. When considering Figure 8, that plots best depth ((Bid Price * Bid Size) + (Ask Price * Ask Size)), there appears to be a monotonic decline across the sample period that relates to the decline in message traffic and trade activity. This trend is consistent across the quartiles, and is particularly pronounced at 1 April 2012.

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50 45 40 35 30 25 20 15 10 5 1/01/2011 1/02/2011 1/03/2011 1/04/2011 1/05/2011 1/06/2011 1/07/2011 1/08/2011 1/09/2011 1/10/2011 1/11/2011 1/12/2011 1/01/2012 1/02/2012 1/03/2012 1/04/2012 1/05/2012 1/06/2012 1/07/2012 1/08/2012 0 Q1 Q2 Q3 Q4

Figure 6. Quoted spread (bp). This figure illustrates the average daily quoted spread (basis points) over the 1/1/2011 - 1/8/2012 sample period. Stocks are segmented into quartiles based on market capitalization.

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20 18 16 14 12 10 8 6 4 2 1/01/2011 1/02/2011 1/03/2011 1/04/2011 1/05/2011 1/06/2011 1/07/2011 1/08/2011 1/09/2011 1/10/2011 1/11/2011 1/12/2011 1/01/2012 1/02/2012 1/03/2012 1/04/2012 1/05/2012 1/06/2012 1/07/2012 1/08/2012 0 Q1 Q2 Q3 Q4

Figure 7. Effective spread. This figure the average daily effective spread (basis points) over the 1/1/2011 - 1/8/2012 sample period. Stocks are segmented into quartiles based on market capitalization.

24

90000 80000 70000 60000 50000 40000 30000 20000 10000 1/01/2011 1/02/2011 1/03/2011 1/04/2011 1/05/2011 1/06/2011 1/07/2011 1/08/2011 1/09/2011 1/10/2011 1/11/2011 1/12/2011 1/01/2012 1/02/2012 1/03/2012 1/04/2012 1/05/2012 1/06/2012 1/07/2012 1/08/2012 0 Q1 Q2 Q3 Q4

Figure 8. Best depth. This figure illustrates the average daily best depth ($) over the 1/1/2011 - 1/8/2012 sample period. Stocks are segmented into quartiles based on market capitalization.

IV. MESSAGE TRAFFIC, TRADING, AND MARKET QUALITY To this point, the study has observed graphical time-series representations quote and trade activity, proxies for AT, and market quality metrics. Panel data regression analysis on the various liquidity variables with respect to the Order Submission trading proxies offers a robust interpretation of this relation. Following Hendershott, Jones, and Menkveld (2011) a two way date (day) and stock fixed effects regression is

25

estimated. Based on the documented association between an increase in order-to-trade ratios (AT) and liquidity provision, liquidity measures (Lit); quoted spread, effective spread, and log depth, are regressed on the log of the individual stock OTT ratio measures (Ait), and variables controlling for market conditions: (Xit): Lit = i + Ait + Xit + it Where Lit is a spread measure for stock i in interval t, Ait is the OTT ratio measure, and Xit is a vector of control variables, including log share turnover, volatility, the inverse of share price, and log market cap. Table II presents regression estimates for the aforementioned measures of liquidity; effective spread, quoted spread, and log best depth on the log of the OTT ratio measure. Regressions are estimated using the data set consisting of trade-by-trade and quote level data for the top 60 market capitalized, continuously listed shares on Chi-X Canada from 1 January, 2011 to 1 August, 2012, which covers the phase-in of IIROC 2012 Integrated Fee Model (1 April 2012). Coefficients for the control variables are presented for the overall sample period and also for market capitalization quartiles. Results for the entire sample of 60 stocks indicate a statistically significant relation between the OTT ratio measure, and effective and quoted spreads with coefficients (t-statistics) of -0.000175 (-18.8) and -0.000456 (-21.72) respectively. When considering best depth as the dependent variable the independent variable OTT ratio measure has a coefficient of 0.017377 and t-statistic of 4.38. For quartiles based on stock market capitalization (quartile 1 being the largest market cap) all four quartiles exhibit a similar and consistent statistically significant relation between the OTT ratio measure and effective spread, quoted spread, and depth. Coefficients (t-statistics) are analogous in sign yet vary in

26

magnitude with respect to effective and quoted spread; from -0.00004 (-5.03) in quartile 1 to -0.00032 (-14.06) in quartile 3 for effective spread, and -0.0001 (-5.78) in quartile 1 to -0.00078 (-15.72) in quartile 3 for quoted spread. This relation weakens when considering quartile 4, which is seen to have a significantly higher OTT ratio and effective and quoted spread compared to the other quartiles. As an additional test regressions are run using a normalized (by $ trading volume) measure of message traffic. Results for this normalized measure of OTT reveal no statistically significant relation with spread measures of liquidity. These results suggest that the relation between OTT ratio measure and effective and quoted spread liquidity measures are driven by the size of the firm, which is endogenously related to liquidity and $ trading volume. These findings are consistent with Hendershott, Jones, and Menkveld that suggest high OTT ratio trading strategies that they proxy for AT, are concentrated in liquid large market-cap stocks. When considering the relation between the OTT ratio measure and the depth dependent variable a different relation emerges; coefficients (t-statistics) decline from 0.16681 (19.46) to 0.02996 (3.16) in quartile 3, to -0.06282 (-9.74) in quartile 4 suggesting that the positive relation between depth and the OTT ratio measure for the total sample is driven by the weightings of the larger market capitalization stocks. The relation between the OTT ratio measure and depth suggests that additional marginal message traffic-to-trades in the higher market capitalization firms is associated with an increase in depth, while an increase in message traffic-to-trades in lower market capitalization stocks is associated with a lower best depth. Because the measures of OTT and depth relate to message traffic that occurs at the best bid and ask, and on market trading activity a possible explanation for this relation could be that the narrower spreads in the more liquid (higher market capitalization) stocks sees heightened message traffic (including quote submission) leading directly to increased depth at the best bid and ask,

27

while increased message traffic relative to trades in less liquid smaller-cap stocks could be associated with price improvement at the best bid and ask, with lower associated cumulative depth.

28

Table II Q Dependent Variable Mean Effective Spread t-statistics Mean Quoted Spread t-statistics Mean Best Depth t-statistics Mean Effective Spread t-statistics Mean Quoted Spread t-statistics Mean Best Depth t-statistics Mean Effective Spread t-statistics Mean Quoted Spread t-statistics Mean Best Depth t-statistics Mean Effective Spread t-statistics Mean Quoted Spread t-statistics Mean Best Depth t-statistics Mean Effective Spread t-statistics Mean Quoted Spread t-statistics Intercept 0.0138 13.63 0.0288 12.65 10.3475 24.02 0.0042 4.2 0.0095 4.49 -6.3437 -6.33 0.0009 0.72 0.0028 0.96 9.3443 9.59 0.0427 18.95 0.0919 18.03 19.0462 20.21 0.0149 5.29 0.0336 5.28 OTT -0.000175 -18.8 -0.000456 -21.72 0.017377 4.38 -0.00004 -5.03 -0.0001 -5.78 0.16681 19.46 -0.00008 -7.04 -0.00022 -8.19 0.07797 8.49 -0.00032 -14.06 -0.00078 -15.27 0.02996 3.16 -0.00016 -7.65 -0.00046 -9.7 Volatility 0.00534 12.8 0.01197 12.71 -3.87148 -21.75 0.00172 4.54 0.00379 4.79 -4.23007 -11.22 0.00276 7.03 0.00618 6.86 -3.41897 -11.23 0.00497 6.04 0.01125 6.03 -5.027 -14.58 0.01133 8.67 0.02464 8.38 Share Turnover -0.00035 -33.75 -0.00087 -36.69 0.12249 27.41 -0.00013 -14.16 -0.00029 -15.79 0.26165 29.62 -0.0002 -16.22 -0.00048 -16.79 0.19871 20.37 -0.00044 -18.88 -0.00105 -19.94 0.15177 15.61 -0.00046 -17.17 -0.00116 -19 Market Cap -0.000581 -13.75 -0.001214 -12.73 0.059632 3.31 -0.00018 -4.41 -0.0004 -4.72 0.69267 17.09 -0.00004 -0.81 -0.00012 -1.02 0.0401 0.98 -0.00171 -18.16 -0.00367 -17.23 -0.26163 -6.63 -0.00065 -5.22 -0.00146 -5.2 Inverted Price -0.00791 -11.87 -0.01655 -11 -1.81614 -6.39 -0.003 -1.92 -0.0069 -2.15 19.6244 12.84 0.0025 2.59 0.0047 2.14 1.0379 1.41 -0.044 -26.64 -0.0968 -25.89 -18.0599 -26.12 -0.0006 -0.45 -0.0009 -0.31 R-Square 0.3696 0.3881 0.8036 0.3544 0.3762 0.8039 0.3661 0.366 0.808 0.3584 0.3638 0.7623 0.3944 0.4191

ALL 1 2 3 4

29

Mean Best Depth t-statistics

7.3494 8.5

-0.06282 -9.74

-4.13238 -10.35

0.06328 7.66

0.1448 3.8

0.1385 0.34

0.7897

Table II Message Traffic and Liquidity: Market Capitalisation Quartiles This table presents regression estimates for various measures of liquidity; effective spread, quoted spread, and best depth on the Order-to-Trade (OTT) Ratio measure. Regressions are estimated using the data set consisting of trade by trade and quote level data for the top 60 market capitalized, continuously listed shares on Chi-X Canada from 1 January, 2011 to 1 August, 2012, which covers the phase-in of IIROC 2012 Integrated Fee Model (1 April 2012). The specification is: Lit = i + t + Ait + Xit + it Where Lit is a liquidity measure for stock i on day t, Ait is the OTT measure, and Xit is a vector of control variables, including share turnover, volatility, 1/price, and log market cap. Coefficients for the control variables are presented for the overall sample period and also for market capitalisation quartiles. Fixed effects and time dummies are included. The set of instruments consists of all independent variables. There are separate regressions for each size quintile, and t-values in parentheses are based on standard errors that are robust to general cross-section and time-series heteroskedasticity and within-group autocorrelation (Hendershott, Jones, and Menkveld 2011).

In Table III and IV the previously specified regressions are estimated for quartiles sorted by message traffic and trading activity respectively. By examining quartiles for message traffic and trades the relation between OTT and liquidity measures can be examined for stocks with high message traffic and trading activity. Extant academic literature and consulting papers characterizes AT and HFT liquidity providers as trading frequently in small trade sizes, with dynamic order monitoring (Brogaard 2010; Menkveld 2012; SEC 2010). Results in Table II suggest that for higher market capitalization firms, the OTT ratio measure is related to narrowing effective and quoted spreads and improvements in best depth, a relation surmised to be due to higher liquidity of the larger firms or possibly heightened overall HFT activity (Brogaard 2010). Results for Message traffic quartiles in Table III show that for effective spread the OTT ratio measure is a statistically significant explanatory variable in quartile 1 with a coefficient (t-statistics) of -0.00003 (-4.1) increasing in magnitude to -0.00066 (-12.61) in quartile 4. For quoted spread the OTT ratio measure exhibits a similar trends; a statistically significant explanatory variable in quartile 1 with a coefficient (t-

30

statistics) of -0.00008 (-4.69) declining to -0.00066 (-12.61) in quartile 4. For stocks that have higher message traffic, the benefits of increased OTT activity appear to be lower than for stocks with lower message traffic. Results for the Depth dependent variable offer an interesting insight into the relation between OTT ratio measure and Depth. For quartiles 1 and 2 the OTT coefficients (t-statistics) are 0.141764 (17.91) and 0.313391 (27.83) while for quartiles 3 and 4 coefficients (tstatistics) are -0.03212 (-4) and -0.06875 (-10.6) These results for liquidity variables suggest that for different message traffic quartiles OTT ratio measure has a range of impacts of effective and quoted spread, and depth. Stocks that have higher message traffic experience a positive relation between the OTT ratio measure and depth, while lower message traffic stocks experience a negative relation. When comparing results between Table II and III, it can be inferred that message traffic is not synonymous with market capitalization. Results in Quartile 2 are inconsistent with this broader trend warranting further analysis with respect to trading activity (Table IV). Results for trading activity quartiles in Table IV suggest that for effective spread OTT ratio measure is a statistically significant explanatory variable in quartile 1 with a coefficient (t-statistics) of -0.00005 (-4.35) increasing in magnitude to -0.0002 (-9.35) in quartile 4. For quoted spread OTT ratio measure is a statistically significant explanatory variable in quartile 1 with a coefficient (t-statistics) of -0.0001 (-4.42) declining to 0.00053 (-11.1) in quartile 4. Results for quartiles based on trading activity suggest that for stocks that have higher trading activity the relation between OTT ratio measure and spread based liquidity measures is weaker than for stocks that have lower trading activity. When considering the dependent variable depth, the OTT ratio measure features a coefficient (t-statistics) of 0.262719 (24.03) in quartile 1 declining to -0.03031 (6.27) in quartile 4. For stocks with lower trading activity, and presumably lower AT activity, the relation between OTT ratio measure and depth

31

becomes negative and weakens.

Table III Q Dependent Variable Mean Effective Spread t-statistics Mean Quoted Spread t-statistics Mean Best Depth t-statistics Mean Effective Spread t-statistics Mean Quoted Spread t-statistics Mean Best Depth t-statistics Mean Effective Spread t-statistics Mean Quoted Spread t-statistics Mean Best Depth t-statistics Mean Effective Spread t-statistics Mean Quoted Spread t-statistics Mean Best Depth t-statistics Intercept -0.00007 -0.08 0.000332 0.18 -4.82033 -5.52 0.000773 2.29 0.001596 2.17 6.976868 7.25 0.057353 21.65 0.125356 21 41.36636 37.6 0.026807 3.52 0.026807 3.52 2.840215 2.99 OTT -0.00003 -4.1 -0.00008 -4.69 0.141764 17.91 0.000029 7.47 0.000052 6.11 0.313391 27.83 -0.00016 -8.41 -0.00039 -9.01 -0.03212 -4 -0.00066 -12.61 -0.00066 -12.61 -0.06875 -10.6 Volatility 0.001597 5.59 0.003449 5.79 -3.66237 -13.31 0.001504 15.8 0.003255 15.73 -4.55312 -16.77 0.011447 11.3 0.025834 11.32 -4.41493 -10.5 0.031043 9.21 0.031043 9.21 -4.09277 -9.75 Share Turnover -0.0001 -10.84 -0.00022 -11.54 0.260817 29.41 -0.00002 -5.63 -0.00005 -6.15 0.411545 40.03 -0.0004 -17.74 -0.00095 -18.74 0.119402 12.75 -0.00127 -20.33 -0.00127 -20.33 0.032801 4.22 Market Cap -6.90E-07 -0.02 -0.00002 -0.25 0.637305 17.79 -0.00004 -2.82 -0.00008 -2.57 0.180989 4.55 -0.00235 -21.58 -0.00514 -20.95 -1.23335 -27.3 -0.00115 -3.43 -0.00115 -3.43 0.33621 8.06 Inverted Price 0.0033 4.14 0.006982 4.2 13.15399 17.16 0.004138 17.37 0.009174 17.71 4.693825 6.91 -0.06053 -34.84 -0.1333 -34.05 -29.718 -41.19 -0.00016 -0.05 -0.00016 -0.05 0.505126 1.28 R-Square 0.3752 0.391 0.7831 0.6728 0.6926 0.8463 0.4211 0.4228 0.6861 0.3952 0.42 0.8035

Table III Message Traffic and Liquidity: Message Traffic Quartiles

32

This table presents regression estimates for various measures of liquidity; effective spread, quoted spread, and best depth on the Order to Trade (OTT) Ratio measure. Regressions are estimated using the data set consisting of trade by trade and quote level data for the top 60 market capitalized, continuously listed shares on Chi-X Canada from 1 January, 2011 to 1 August, 2012, which covers the phase-in of IIROC 2012 Integrated Fee Model (1 April 2012). The specification is: Lit = i + t + Ait + Xit + it Where Lit is a liquidity measure for stock i on day t, Ait is the OTT measure, and Xit is a vector of control variables, including share turnover, volatility, 1/price, and log market cap. Coefficients for the control variables are presented for the overall sample period and also for message traffic quartiles. Fixed effects and time dummies are included. The set of instruments consists of all independent variables. There are separate regressions for each quartile, and t-values in parentheses are based on standard errors that are robust to general cross-section and time-series heteroskedasticity and within-group autocorrelation (Hendershott, Jones, and Menkveld 2011).

Table IV Q Dependent Variable Mean Effective Spread t-statistics Mean Quoted Spread t-statistics Mean Best Depth t-statistics Mean Effective Spread t-statistics Mean Quoted Spread t-statistics Mean Best Depth t-statistics Mean Effective Spread t-statistics Mean Quoted Spread t-statistics Mean Best Depth t-statistics Mean Effective Spread t-statistics Mean Quoted Spread Intercept 0.001313 1.74 0.00256 1.64 10.4178 13.78 -0.0013 -3.39 -0.00553 -6.86 5.688918 7.73 0.044813 24.28 0.096832 23.44 19.17555 21.27 0.020131 3.81 0.045742 OTT -0.00005 -4.35 -0.0001 -4.42 0.262719 24.03 -0.00006 -9.3 -0.00014 -10.58 0.209752 17.97 -0.00007 -3.29 -0.00016 -3.69 0.104326 10.77 -0.0002 -9.3 -0.00053 Volatility 0.000996 3.83 0.002067 3.85 -5.43341 -20.86 0.001695 10.06 0.003677 10.41 -6.66325 -20.66 0.007876 10.38 0.017693 10.42 -4.56459 -12.32 0.01278 8.59 0.027311 Share Turnover -0.00009 -9.21 -0.00018 -9.14 0.371096 37.94 -0.00008 -15.81 -0.00019 -17.17 0.384702 37.66 -0.00024 -12.19 -0.00058 -12.82 0.229915 23.49 -0.00052 -18.49 -0.00128 Market Cap -0.00006 -1.77 -0.00011 -1.64 0.032288 1.03 0.000049 3.11 0.000219 6.58 0.226386 7.45 -0.00182 -23.89 -0.00392 -23.06 -0.3094 -8.33 -0.00086 -3.81 -0.00196 Inverted Price 0.002936 5.4 0.006981 6.21 4.029577 7.4 0.003855 21.63 0.01135 30.38 3.015877 8.84 -0.05384 -38.21 -0.11798 -37.41 -23.0431 -33.48 -0.03467 -3.32 -0.07382 R-Square 0.356 0.3917 0.802 0.7527 0.8101 0.8136 0.4228 0.4212 0.649 0.3862 0.41

33

t-statistics Mean Best Depth t-statistics

3.84 4.084979 3.36

-11.1 -0.03031 -6.27

8.14 0.828403 2.42

-20.13 -0.02305 -3.55

-3.85 0.252827 4.87

-3.14 -5.73204 -2.39

0.5958

Table IV Message Traffic and Liquidity: Trading Activity Quartiles This table presents regression estimates for various measures of liquidity; effective spread, quoted spread, and best depth on the Order to Trade (OTT) Ratio measure. Regressions are estimated using the data set consisting of trade by trade and quote level data for the top 60 market capitalized, continuously listed shares on Chi-X Canada from 1 January, 2011 to 1 August, 2012, which covers the phase-in of IIROC 2012 Integrated Fee Model (1 April 2012). The specification is: Lit = i + t + Ait + Xit + it Where Lit is a liquidity measure for stock i on day t, Ait is the OTT measure, and Xit is a vector of control variables, including share turnover, volatility, 1/price, and log market cap. Coefficients for the control variables are presented for the overall sample period and also for trading activity quartiles. Fixed effects and time dummies are included. The set of instruments consists of all independent variables. There are separate regressions for each quartile, and t-values are based on standard errors that are robust to general cross-section and time-series heteroskedasticity and within-group autocorrelation (Hendershott, Jones, and Menkveld 2011).

Results for OTT quartiles in Table V suggest that for effective spread the OTT ratio measure is a statistically significant explanatory variable in quartile 1 with a coefficient (t-statistics) of -0.00016 (-7.98) increasing to -0.00006 (-8.56) in quartile 4. For quoted spread OTT ratio measure is a statistically significant explanatory variable in quartile 1 with a coefficient (t-statistics) of -0.00042 (-9.51) increasing to -0.00013 (9.18) in quartile 4. Results for the Depth dependent variable offer an interesting insight into the relation between OTT ratio measure and Depth with respect to OTT quartiles. For quartiles 1 the OTT coefficients (t-statistics) are -0.0132 (-2.77), while the OTT coefficients are increase to 0.027032 (3.27) in quartile 2 and 0.28812 (26.56) and 0.207933 (15.67) in quartiles 3 and 4 respectively. These results suggest that for stocks with higher OTT ratios, the relation between OTT and depth is negative and weaker while the relation strengthens and is positive for stocks with lower

34

OTT ratios; namely in quartiles 3 and 4.

Table V Q Dependent Variable Mean Effective Spread t-statistics Mean Quoted Spread t-statistics Mean Best Depth t-statistics Mean Effective Spread t-statistics Mean Quoted Spread t-statistics Mean Best Depth t-statistics Mean Effective Spread t-statistics Mean Quoted Spread t-statistics Mean Best Depth t-statistics Mean Effective Spread t-statistics Mean Quoted Spread t-statistics Mean Best Depth t-statistics Intercept 0.018537 4.15 0.043439 4.29 7.854285 7.26 0.05 23.58 0.108695 22.81 29.30767 38.45 0.000693 0.73 0.001131 0.56 -5.06041 -5.08 -0.00168 -3.53 -0.00747 -7.53 20.59273 21.35 OTT -0.00016 -7.98 -0.00042 -9.51 -0.0132 -2.77 -0.0003 -13.16 -0.00073 -14.15 0.027032 3.27 -6.08E-06 -0.59 -0.00003 -1.27 0.28812 26.56 -0.00006 -8.56 -0.00013 -9.18 0.207933 15.67 Volatility 0.008635 7.17 0.018766 6.88 0.003629 0.01 0.00692 7.69 0.015602 7.71 -3.38014 -10.45 0.001759 5.63 0.003974 6 -6.54593 -20.06 0.001865 10.76 0.003889 10.8 -9.19459 -26.25 Share Turnover -0.00045 -17.37 -0.00113 -19.22 -0.00623 -0.99 -0.00052 -21.09 -0.00122 -21.98 0.081594 9.18 -0.00009 -9.38 -0.00021 -10.6 0.472393 48.03 -0.00007 -13.63 -0.00016 -13.64 0.356525 32.14 Market Cap -0.00078 -4.12 -0.00184 -4.27 0.101037 2.19 -0.00218 -23.72 -0.00473 -22.92 -0.829 -25.13 -0.00004 -1 -0.00007 -0.82 0.672114 16.61 0.000071 3.51 0.000315 7.49 -0.38501 -9.4 Inverted Price -0.02771 -3.02 -0.06693 -3.23 -27.0546 -12.19 -0.04484 -26.14 -0.09852 -25.55 -20.4429 -33.15 0.002624 3.13 0.005099 2.87 12.80979 14.6 0.004193 21.38 0.012318 30.22 -0.84237 -2.13 R-Square 0.4125 0.4331 0.7188 0.3724 0.3787 0.7942 0.4148 0.4411 0.8572 0.7525 0.8147 0.8836

Table V Message Traffic and Liquidity: OTT Quartiles

35

This table presents regression estimates for various measures of liquidity; effective spread, quoted spread, and best depth on the Order to Trade (OTT) Ratio measure. Regressions are estimated using the data set consisting of trade by trade and quote level data for the top 60 market capitalized, continuously listed shares on Chi-X Canada from 1 January, 2011 to 1 August, 2012, which covers the phase-in of IIROC 2012 Integrated Fee Model (1 April 2012). The specification is: Lit = i + t + Ait + Xit + it Where Lit is a liquidity measure for stock i on day t, Ait is the OTT measure, and Xit is a vector of control variables, including share turnover, volatility, 1/price, and log market cap. Coefficients for the control variables are presented for the overall sample period and also for OTT quartiles. Fixed effects and time dummies are included. The set of instruments consists of all independent variables. There are separate regressions for each size quintile, and t-values in parentheses are based on standard errors that are robust to general cross-section and time-series heteroskedasticity and within-group autocorrelation (Hendershott, Jones, and Menkveld 2011).

As an additional test this study employs Hendershott, Jones, and Menkvelds (2011) measure; ALGO, of normalized message traffic by trading volume ($). Table VI presents regression estimates for the aforementioned measures of liquidity; effective spread, quoted spread, and best depth on this ALGO measure. Coefficients for the control variables are presented for the overall sample period and also for market capitalization quartiles. Controlling for changes in volume/price, results for the entire sample of 60 stocks indicate a statistically significant relation between the ALGO proxy, and effective and quoted spreads with coefficients (t-statistics) of -0.0006 (-2.79) and -0.00128 (-2.62) respectively. When considering best depth as the dependent variable the ALGO proxy independent variable has a coefficient of -0.16871 and t-statistic of -1.84 (significant at 0.05). When considering quartiles for stock market capitalization (quartile 1 being the largest market cap) quartiles 1 3 exhibit a similar statistically significant relation between the ALGO proxy and effective spread and quoted spread. Coefficients (t-statistics) are analogous in sign yet vary in magnitude with respect to effective and quoted spread; from -0.00121 (-1.43) in quartile 1 to -0.02279 (-13.5) in quartile 3 for effective spread, and -0.00372 (-2.09) in quartile 1 to -0.0548 (-14.3) in quartile 3 for quoted spread. These results suggest that the relation

36

between ALGO and Effective and Quoted spread liquidity measures are driven by the size of the firm; with coefficients and t-statistics increasing in size as marker capitalization increases. Results for Quartile 4 reveal an insignificant relation between ALGO and spread measures, which supports the notion that AT market making is more prevalent in stocks that have a higher OTT ratio. When considering the relation between ALGO proxy and the depth dependent variable a different relation emerges; coefficients (tstatistics) decline from 7.73021 (8.94) to -0.35688 (-3.44) in quartile 4 suggesting that the positive relation between depth and the ALGO proxy for the entire sample is driven by AT activity, and high order submission relative to trading activity.

37

Table VI Q Dependent Variable Mean Effective Spread t-statistics Mean Quoted Spread t-statistics Mean Best Depth t-statistics Mean Effective Spread t-statistics Mean Quoted Spread t-statistics Mean Best Depth t-statistics Mean Effective Spread t-statistics Mean Quoted Spread t-statistics Mean Best Depth t-statistics Mean Effective Spread t-statistics Mean Quoted Spread t-statistics Mean Best Depth t-statistics Mean Effective Spread t-statistics Mean Quoted Spread t-statistics Mean Best Depth Intercept 0.0141 13.88 0.0297 12.91 10.3465 24 0.004 3.93 0.0089 4.21 -5.5348 -5.39 0.0016 1.28 0.005 1.7 8.949 9.04 0.0436 19.36 0.0943 18.46 18.7924 19.97 0.0148 5.19 0.033 5.14 7.4466 ALGO -0.0006 -2.79 -0.00128 -2.62 -0.16871 -1.84 -0.00121 -1.43 -0.00372 -2.09 7.73021 8.94 -0.00321 -3.6 -0.00979 -4.78 1.51765 2.19 -0.02279 -13.5 -0.0548 -14.3 -2.89902 -4.11 0.00018 0.54 0.00053 0.69 -0.35688 Volatility 0.00513 12.2 0.01141 12 -3.84593 -21.6 0.00166 4.37 0.00365 4.6 -4.00003 -10.35 0.00261 6.63 0.00579 6.42 -3.24284 -10.61 0.00476 5.77 0.01071 5.73 -4.97582 -14.44 0.01138 8.67 0.02477 8.36 -4.10758 Share Turnover -0.00029 -28.92 -0.0007 -30.84 0.11461 27.11 -0.00011 -13.05 -0.00026 -14.62 0.21149 24.58 -0.00018 -14.9 -0.00043 -15.38 0.17039 18 -0.00042 -18.42 -0.001 -19.28 0.12345 12.88 -0.00042 -15.8 -0.00104 -17.19 0.0749 Market Cap -0.000614 -14.41 -0.001297 -13.46 0.061249 3.4 -0.00017 -4.23 -0.00039 -4.54 0.67679 16.26 -0.00008 -1.56 -0.00024 -1.98 0.06563 1.57 -0.0018 -19.12 -0.00389 -18.24 -0.25034 -6.37 -0.00067 -5.32 -0.00151 -5.32 0.13056 Inverted Price -0.00727 -10.84 -0.01485 -9.8 -1.89101 -6.66 -0.0014 -0.92 -0.0031 -1 13.6315 8.88 0.0026 2.75 0.005 2.28 0.7631 1.03 -0.0396 -23.8 -0.0862 -22.85 -17.8473 -25.68 -0.0001 -0.07 0.0005 0.16 0.2702 R-Square 0.3604 0.3761 0.8035 0.3518 0.373 0.7936 0.362 0.361 0.8057 0.3567 0.3606 0.7626 0.3881 0.4094 0.7866

ALL 1 2 3 4

38

t-statistics

8.54

-3.44

-10.21

9.1

3.4

0.66

Table VI Normalised Message Traffic and Liquidity: Market Capitalisation Quartiles This table presents regression estimates for various measures of liquidity; effective spread, quoted spread, and best depth on the Normalized Order to Trade Value (ALGO) Ratio measure. Regressions are estimated using the data set consisting of trade by trade and quote level data for the top 60 market capitalized, continuously listed shares on Chi-X Canada from 1 January, 2011 to 1 August, 2012, which covers the phase-in of IIROC 2012 Integrated Fee Model (1 April 2012). The specification is: Lit = i + t + Ait + Xit + it Where Lit is a liquidity measure for stock i on day t, Ait is the Normalized Order to Trade Value algorithmic trading proxy ALGO, and Xit is a vector of control variables, including share turnover, volatility, 1/price, and log market cap. Coefficients for the control variables are presented for the overall sample period and also for market capitalisation quartiles. Fixed effects and time dummies are included. The set of instruments consists of all independent variables. There are separate regressions for each size quintile, and t-values in parentheses are based on standard errors that are robust to general cross-section and time-series heteroskedasticity and within-group autocorrelation (Hendershott, Jones, and Menkveld 2011).

As an additionally robustness test, Table VII presents regression estimates for various non-spread variables on the OTT Ratio Measure for the entire sample of 60 stocks, as well as for stock market capitalization quartiles. The regression is specified as:

Mit = i + t + Ait + it,

where Mit is a non-spread variable for stock i on day t, and Ait is the OTT / AT proxy; OTT, ALGO, and Quotes. Fixed time and firm effects are included. Panel A presents Share Turnover, Trade Size, and Trades as dependent variables on the OTT independent variable. For the total sample OTT is a negative and statistically significant explanatory variable for Share turnover and Trades with coefficients of -0.34174 and .3455 respectively. This relation is consistent across the market capitalization quartiles, with coefficients with respect to share turnover

39

increasing from -0.46472 in quartile 1 to -0.18018 in quartile 4. Similarly, statistically coefficients with respect to Trades increase from -0.54774 to -0.16282. Results in Panel B suggest a negative and statistically significant relation between the ALGO explanatory variable and Share turnover, Trade Size and Trades robust across the quartiles. Results in Panel C suggest a positive and statistically significant relation between quotes and the dependent variable Share turnover and trades, across the quartiles. When considering the trade size dependent variable, quotes are a negative and statistically significant explanatory variable for the entire sample. Results in Table VII imply that AT, and quote submission is associated with lower average trade size in line with the associated relation discussed in the literature review.

40

Table VII Dependent Variable Share Turnover (t-statistics) Trade Size (t-statistics) Trades (t-statistics) Share Turnover (t-statistics) Trade Size (t-statistics) Trades (t-statistics) Share Turnover (t-statistics) Trade Size (t-statistics) Trades (t-statistics) All Coefficient -0.34174 -61.67 0.05509 19.69 -0.3455 -60.53 -2.96472 -20.2 -0.42718 -6.12 -2.59444 -17.17 0.38555 79.62 -0.06243 -24.55 0.45417 95.41 R2 0.7347 0.7983 0.8585 Quartile 1 Coefficient R2 -0.46472 -40.47 0.13156 26.25 -0.54774 -46.81 -33.4667 -24.82 1.11607 1.93 -34.7896 -24.36 0.50867 44.79 -0.0261 -4.86 0.53524 44.51 Quartile 2 Coefficient R2 Quartile 3 Coefficient R2 0.7439 0.655 0.774 Quartile 4 Coefficient R2 -0.18018 -16.48 0.01095 2.91 -0.16282 -15.4 -1.42274 -7.85 -0.13667 -2.23 -1.28045 -7.32 0.35681 42.17 -0.02962 -9.13 0.36993 46.47 0.7429 0.8701 0.8465

Panel A: Independent Variable: OTT -0.42109 -0.44818 0.7374 0.7583 -36.4 -38.02 0.08478 0.7547 0.06479 0.828 10.32 10.22 -0.37756 -0.46638 0.816 0.843 -33.86 -34.6 Panel B: Independent Variable: ALGO -24.9504 -29.3333 0.6943 0.733 -25.81 -31.01 -8.55775 -9.03716 0.7247 0.8336 -17.26 -14.33 -20.7794 -20.3843 0.7687 0.8263 -22.29 -18.25 Panel C: Independent Variable: Quotes 0.38593 0.39035 0.7501 0.7533 34.4 37.77 0.0394 -0.19591 0.7257 0.8261 6.44 -28.94 0.42639 0.59094 0.811 0.8553 41.5 57.19

0.6973 0.7953 0.8386

0.725 0.6609 0.7411

0.7334 0.87 0.8416

0.7571 0.8 0.882

0.7432 0.6941 0.8267

0.7953 0.8718 0.8845

Table VII Effect of Message Traffic on Non-spread Variables This table presents regression estimates for various non-spread variables on the Order to Trade (OTT) Ratio measure. Regressions are estimated using the data set consisting of trade by trade and quote level data for the top 60 market capitalized, continuously listed shares on Chi-X Canada from 1 January, 2011 to 1 August, 2012, which covers the phase-in of IIROC 2012 Integrated Fee Model (1 April 2012). The specification is:

41

Mit = i + t + Ait + it Where Mit is a non-spread variable for stock i on day t, and Ait is the message traffic measure; OTT, ALGO, and Quotes. Fixed effects are included. t-values are based on standard errors that are robust to general cross-section and time-series heteroskedasticity and within-group autocorrelation (Hendershott, Jones, and Menkveld 2011).

V. MESSAGE TRAFFIC, TRADING, MARKET QUALITY, AND THE IRROC INTEGRATED FEE MODEL The IIROC Integrated Fee Model determines the net costs allocated to each Marketplace Member on a pro rata basis and are paid by that Marketplaces participating organizations based on the number of messages sent and trades executed by each Dealer Member on each Marketplace. To this point this study has identified a positive link between improvements in liquidity measures and OTT based proxies of AT; OTT and ALGO across the 1 January 2011 to 1 August 2012 sample period. Results correspond with Hendershott, Jones, and Menkveld (2011) that suggest that high OTT ratio trading strategies are linked to improvements in liquidity measures. Market participants, including Bank of America Merrill Lynch (BAML, 2012) and submissions to IIROC and ASIC raise concerns over the impact of a fee structure based on the number of messages sent and trades executed by each Dealer Member on each Marketplace due to the inference that such a fee structure would adversely impact high OTT strategies, including HFT, ultimately reducing quote activity and market quality. It follows that Table VIII presents results for t-tests for the difference in Trades, Message Traffic, Volatility, Trade Value, Volume, ALGO, OTT, and Liquidity measures with respect to the introduction of the IIROC 2012 Integrated Fee Model (1 April 2012). Results are generated using the data set consisting of trade-by-trade and quote level data for the top 60 market capitalized, continuously listed shares on Chi-

42

X Canada from 1 January, 2011 to 1 August, 2012. The pre sample spans 1 January 2011 to 1 April 2012, while the post sample spans 1 April 2012 to 1 August 2012. t-statistics for the difference between the two means are presented in parenthesis. The mean number of trades does not offer a statistically significant difference for the entire sample and for the 1st and 2nd quartiles between the pre and post sample periods. The 3rd quartile exhibits a statistically increase of 232.65 mean trades, while the 4th quartile exhibits a statistically significant decrease of 83.89. Results for message traffic suggest that the introduction of the IIROC 2012 Integrated Fee Model has led to a statistically significant decrease of 18821 between the pre and post- samples, this results is robust across the market capitalization quartiles. The introduction of the Integrated Fee Model appears to have curbed message traffic across the sample. For both the OTT measure and ALGO AT proxy, the introduction of the IIROC 2012 Integrated Fee Model appears to have decreased the incidence of message traffic, and AT proxy measures for the entire sample, and also for the 1st three quartiles. Results have previously positively linked OTT ratio and ALGO to improvements in spread based liquidity measures, for Quartiles 1 and 3 there is a statistically significant increase in effective spread of 0.4263 and .9224 bp respectively. This relation weakens into the smaller market cap quartiles, consistent with studies that suggest that AT is concentrated in higher market cap, liquid stocks. Results for changes in depth suggest that a reduction in AT activity, and quote submission linked to the IIROC 2012 Integrated Fee Model are associated with a decrease in best depth with a statistically significant decline across the entire sample, and also for the 1st three market capitalization quartiles.

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Table VIII Trades Pre Post Pre-Post Pre Post Pre-Post Pre Post Pre-Post Pre Post Pre-Post Pre Post Pre-Post 2253.97 2277.25 -23.28 (-0.72) 3253.91 3268.8 -14.89 (-0.2) 2768.22 2697.7 70.52 (1.22) 2033.14 2265.79 -232.65 (-3.74) 960.63 876.74 83.89 (2.64) ALL 1 2 3 4 Quote Updates 74565 55744 18821 (22.4) 109989 89944 20045 (9.36) 85226 57708 27518 (20.11) 72231 52791 19440 (13.88) 30814 22535 8279 (12.05) Volatility Trade Value 0.02344 0.0232 0.00024 (1.08) 0.01959 0.01877 0.00082 (2.39) 0.02515 0.02583 -0.0007 (-1.42) 0.02721 0.02609 0.00111 (2.35) 0.02181 0.02211 -0.0003 (-0.71) 10019670 8914780 1104890 (6.09) 18968559 17231789 1736769 (5.01) 10572992 8885249 1687743 (9.08) 7372628 7237691 134937 (0.27) 3164503 2304391 860112 (12.32) Volume 318326 339871 -21544 (-2.97) 396998 408529 -11531 (-1.14) 410791 430532 -19741 (-1.64) 277086 334221 -57135 (-2.84) 188429 186200 2229 (0.18) ALGO 0.0105 0.00976 0.00074 (2.64) 0.00629 0.00575 0.00055 (4.65) 0.00914 0.00759 0.00155 (10.41) 0.01081 0.0097 0.00111 (5.02) 0.01576 0.01601 -0.0003 (-0.25) OTT 51.8164 43.8063 8.0101 (4.51) 40.3445 33.745 6.5995 (7) 43.2046 29.2864 13.9182 (14.6) 44.8135 37.013 7.8005 (5.9) 78.9029 75.1808 3.7221 (0.55) Effective Spread 4.6572 4.5545 0.1027 (0.94) 1.7963 2.2225 -0.4263 (-3.27) 3.1627 3.812 -0.6493 (-5.48) 5.1367 4.0017 1.135 (6.69) 8.533 8.1816 0.3514 (1.05) Quoted Spread 10.722 10.6603 0.0621 (0.25) 4.1447 5.0671 -0.9224 (-3.38) 7.2476 8.7341 -1.4865 (-5.61) 11.821 9.371 2.4497 (6.41) 19.6767 19.4689 0.2078 (0.28) Depth 38264.1 32314.2 5949.9 (9.21) 46523 37590.9 8932.1 (17.84) 44389.9 36764.8 7625.06 (11.08) 33628.4 26726.3 6902.1 (4.45) 28515 28174.7 340.3 (0.18)

Table VIII t-tests for the impact of IIROC 2012 Integrated Fee Model This table presents results for t-tests for the difference in Trades, Message Traffic, Volatility, Trade Value, Volume, ALGO, OTT, and Liquidity measures with respect to the introduction of the IIROC 2012 Integrated Fee Model (1 April 2012). Results are generated using the data set consisting of trade by trade and quote level data for the top 60 market capitalized, continuously listed shares on Chi-X Canada from 1 January, 2011 to 1 August, 2012. The pre sample spans 1 January 2011 to 1 April 2012, while the post sample spans 1 April 2012 to 1 August 2012. T-statistics for the difference between the two means are presented in parenthesis.

44

Findings in Table VIII motivate a further analysis of the relation between AT and liquidity measures around the introduction of the IIROC 2012 Integrated Fee Model. Table IX presents regression estimates for various measures of liquidity; effective spread, quoted spread, and best depth on the OTT Ratio measure. Regressions are estimated using the data set consisting of trade-by-trade and quote level data for the top 60 market capitalized, continuously listed shares on Chi-X Canada from 1 January, 2011 to 1 April, 2012, which excludes the phase-in of IIROC 2012 Integrated Fee Model (1 April 2012). Results for the entire sample of 60 stocks indicate a statistically significant relation between the OTT AT proxy, and effective and quoted spreads with coefficients (t-statistics) of -0.00022 (-20.89) and -0.00057 (-23.25) respectively. When considering best depth as the dependent variable the OTT ratio measure independent variable has a coefficient of -0.01204 and t-statistic of 2.77. When considering quartiles for stock market capitalization (quartile 1 being the largest market cap) all four quartiles exhibit a similar relation between the OTT ratio measure and effective spread and quoted spread. Results are statistically significant for quartiles 2 to 4 with coefficients increasing as market capitalization decreases. For quartiles 1 and 2 there is a positive and statistically significant relation between OTT and depth, while the relation is negative and statistically significant in quartiles 3 and 4 respectively. Table X similarly presents regression estimates for various measures of liquidity; effective spread, quoted spread, and best depth on the OTT Ratio measure. Regressions are estimated using the data set consisting of trade-by-trade and quote level data for the top 60 market capitalized, continuously listed shares on Chi-X Canada from 1 January, 2011 to 1 April, 2012, which includes the phase-in of IIROC 2012 Integrated Fee Model (1 April 2012).

45

Table IX Q Dependent Variable Mean Effective Spread t-statistics Mean Quoted Spread t-statistics Mean Best Depth t-statistics Mean Effective Spread t-statistics Mean Quoted Spread t-statistics Mean Best Depth t-statistics Mean Effective Spread t-statistics Mean Quoted Spread t-statistics Mean Best Depth t-statistics Mean Effective Spread t-statistics Mean Quoted Spread t-statistics Mean Best Depth t-statistics Mean Effective Spread t-statistics Mean Quoted Spread t-statistics Mean Best Depth Intercept 0.018362 15.13 0.039057 14.07 16.49264 33.46 0.00204 3.44 0.005273 4.05 2.590233 2.21 0.002209 1.3 0.005801 1.47 5.605857 4.59 0.054026 19.04 0.117171 18.18 26.22966 24.57 0.025217 7.1 0.057891 7.12 15.3553 OTT -0.00022 -20.89 -0.00057 -23.25 -0.01204 -2.77 1.30E-06 0.26 -9.86E-06 -0.9 0.152236 15.37 -0.00012 -8.26 -0.00031 -9.12 0.052682 5.06 -0.00038 -13.74 -0.00094 -14.92 -0.01155 -1.11 -0.00023 -9.92 -0.00061 -11.4 -0.07284 Volatility 0.005256 10.8 0.011933 10.72 -3.15223 -15.95 0.001471 6.64 0.003395 6.97 -3.50642 -8.01 0.00269 5.81 0.00608 5.66 -2.75745 -8.28 0.004523 4.57 0.010303 4.58 -4.51992 -12.13 0.011379 7.55 0.025218 7.3 -2.88689 Share Turnover -0.00042 -33.16 -0.00103 -35.51 0.080095 15.6 -0.00009 -15.69 -0.00021 -17.83 0.225154 21 -0.00024 -15.25 -0.00057 -15.6 0.180618 16.03 -0.00048 -16.01 -0.00115 -16.92 0.115674 10.26 -0.00056 -17.95 -0.00139 -19.38 0.011494 Market Cap -0.00076 -14.83 -0.00161 -13.79 -0.19028 -9.2 -0.00009 -3.67 -0.00023 -4.31 0.317895 6.65 -0.00009 -1.32 -0.00025 -1.48 0.196661 3.82 -0.00217 -18.27 -0.00469 -17.4 -0.55673 -12.47 -0.00106 -6.78 -0.00245 -6.84 -0.20939 Inverted Price -0.01289 -15.27 -0.0274 -14.19 -6.48899 -18.93 -0.00225 -2.75 -0.00545 -3.04 17.53388 10.87 0.000048 0.03 -0.00075 -0.2 7.569782 6.46 -0.05321 -25.28 -0.11731 -24.53 -23.0677 -29.13 -0.00544 -3.43 -0.01184 -3.26 -5.01828 R-Square 0.3968 0.4054 0.8151 0.4289 0.4602 0.8076 0.3344 0.3298 0.8308 0.3941 0.3975 0.7858 0.433 0.4461 0.7875

ALL 1 2 3 4

46

t-statistics

14.61

-10.56

-6.46

1.24

-4.52

-10.7

Table IX Message Traffic and Liquidity: Pre-IIROC 2012 Integrated Fee Model This table presents regression estimates for various measures of liquidity; effective spread, quoted spread, and best depth on the Order to Trade (OTT) Ratio measure. Regressions are estimated using the data set consisting of trade by trade and quote level data for the top 60 market capitalized, continuously listed shares on Chi-X Canada from 1 January, 2011 to 1 April, 2012, which excludes the phase-in of IIROC 2012 Integrated Fee Model (1 April 2012). The specification is: Lit = i + t + Ait + Xit + it Where Lit is a liquidity measure for stock i on day t, Ait is the OTT measure, and Xit is a vector of control variables, including share turnover, volatility, 1/price, and log market cap. Coefficients for the control variables are presented for the overall sample period and also for trading activity quartiles. Fixed effects and time dummies are included. The set of instruments consists of all independent variables. There are separate regressions for each quartile, and t-values are based on standard errors that are robust to general cross-section and time-series heteroskedasticity and within-group autocorrelation (Hendershott, Jones, and Menkveld 2011).

When comparing results in Table IX to Table X; incorporating the phase in of the IIROC 2012 Integrated Fee Model, coefficients for liquidity measures on OTT ratio measure appear to decrease in magnitude and significance. For the entire sample there is a negative, but statistically insignificant, relation between the OTT ratio measure and effective spread. Similarly, the coefficient (t-statistics) for OTT on quoted spread is -0.00009 (-2.26) compared to -0.00057 (-23.25) in the pre-IIROC 2012 Integrated Fee Model sample in Table IX. The relation between OTT and effective and quoted spread deteriorates when considering market capitalization quartiles. There is still a statistically significant relation between OTT and effective and quoted spread in quartile 1 with coefficients (t-statistics) of -0.0002 (-5.56) and 0.00044 (-5.97), however this relation weakens into quartile 2 and 3, and reverses into quartile 4; 0.000132 (2.5) 0.00019 (1.73). When considering depth, there remains a statistically significant and positive relation with OTT for the entire sample, with OTT independent variable coefficients of 0.071616 (8.65). With respect to the market capitalization quartiles, this relation weakens from quartile 1 to 4 suggesting that for

47

higher market capitalization firms OTT is a more significant explanatory variable with respect to depth following the introduction of the IIROC 2012 Integrated Fee Model.
Table X Q Dependent Variable Mean Effective Spread t-statistics Mean Quoted Spread t-statistics Mean Best Depth t-statistics Mean Effective Spread t-statistics Mean Quoted Spread t-statistics Mean Best Depth t-statistics Mean Effective Spread t-statistics Mean Quoted Spread t-statistics Mean Best Depth t-statistics Mean Effective Spread t-statistics Mean Quoted Spread t-statistics Mean Best Depth t-statistics Mean Effective Spread t-statistics Intercept -0.00799 -1.5 -0.02392 -2.15 -20.8184 -9.19 -0.00114 -0.04 -0.00559 -0.1 -43.3636 -3.73 0.007444 1.13 0.014039 0.99 -5.8735 -1.09 -0.02 -2.47 -0.03941 -2.31 -16.2062 -2.47 -0.00515 -0.35 OTT -0.00002 -0.91 -0.00009 -2.26 0.071616 8.65 -0.0002 -5.56 -0.00044 -5.97 0.165889 11.23 4.35E-06 0.16 -0.00005 -0.89 0.211678 9.31 -0.00009 -3.84 -0.00021 -4.42 0.08034 4.32 0.000132 2.5 Volatility 0.004739 6.2 0.0098 6.14 -4.80855 -14.82 0.000844 0.56 0.001589 0.51 -3.75601 -6.02 0.002653 3.63 0.00568 3.63 -4.17068 -6.98 0.002932 3.56 0.006316 3.64 -6.01602 -9.01 0.011095 4.21 Share Turnover -0.0002 -10 -0.00045 -10.95 0.226827 27.29 -0.00021 -6.12 -0.00046 -6.4 0.301245 20.81 -0.00011 -4.42 -0.00026 -5.05 0.213685 10.92 -0.00017 -8.03 -0.0004 -8.92 0.293713 17.09 -0.00026 -4.17 Market Cap 0.000317 1.42 0.000971 2.09 1.353328 14.3 0.000041 0.04 0.000217 0.09 2.163178 4.65 -0.00033 -1.16 -0.00061 -1.01 0.663446 2.89 0.00084 2.53 0.001666 2.38 1.214726 4.5 0.000196 0.31 Inverted Price 0.005579 1.82 0.015276 2.39 13.54764 10.41 0.006782 0.16 0.017709 0.21 88.22596 5.15 0.001176 0.39 0.003843 0.6 11.5142 4.68 0.009222 1.5 0.016038 1.24 -4.57978 -0.92 0.002592 0.28 R-Square 0.3571 0.4242 0.8569 0.352 0.3677 0.8493 0.4949 0.5257 0.8041 0.3589 0.412 0.8105 0.3043

ALL 1 2 3 4

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Mean Quoted Spread t-statistics Mean Best Depth t-statistics

-0.02792 -0.91 -21.2563 -5.6

0.00019 1.73 -0.00746 -0.55

0.022376 4.07 -4.25643 -6.23

-0.00058 -4.56 0.116835 7.34

0.001186 0.89 1.385737 8.38

0.012587 0.65 14.17125 5.93

0.3676 0.8949

Table X Message Traffic and Liquidity: Post-IIROC 2012 Integrated Fee Model This table presents regression estimates for various measures of liquidity; effective spread, quoted spread, and best depth on the Order to Trade (OTT) Ratio measure. Regressions are estimated using the data set consisting of trade by trade and quote level data for the top 60 market capitalized, continuously listed shares on Chi-X Canada from 1 April, 2012 to 1 August, 2012, which includes the phase-in of IIROC 2012 Integrated Fee Model (1 April 2012). The specification is: Lit = i + t + Ait + Xit + it where Lit is a liquidity measure for stock i on day t, Ait is the OTT measure, and Xit is a vector of control variables, including share turnover, volatility, 1/price, and log market cap. Coefficients for the control variables are presented for the overall sample period and also for trading activity quartiles. Fixed effects and time dummies are included. The set of instruments consists of all independent variables. There are separate regressions for each quartile, and t-values are based on standard errors that are robust to general cross-section and time-series heteroskedasticity and within-group autocorrelation (Hendershott, Jones, and Menkveld 2011).

VI. CONCLUSIONS Empirical research suggests a relation between AT and improving market quality; increasing liquidity, price discovery, and reduced volatility (Hendershott, Jones, and Menkveld, 2011; Hasbrouck and Saar, 2010; Brogaard, 2012). Empirical studies characterize AT and HFT liquidity suppliers as trading frequently in small trade sizes, with dynamic order monitoring (Brogaard 2010; Menkveld 2012; SEC 2010). This paper examines the association between high OTT ratio trading strategies; commonly used as a proxy for AT, and broader liquidity based market quality metrics for Chi-X Canada. Using the implementation of IIROCs Integrated Fee Model, on the 1 April 2012, this study is able to examine the impact of regulators fee models that are allocated pro rata with participants order submission and trading strategies on order submission

49

strategies and market quality. To establish causality this study incorporates this important exogenous event that is expected to decrease the amount of message traffic and trades in stocks on Chi-X Canada. This study employs regression analysis to examine the relation between order submission strategies and market quality using a sample of top 60 stocks (market cap) for Chi-X Canada (1/01/2011 to 1/08/2012). This sample period covers the phase-in of IIROC 2012 Integrated Fee Model (1 April 2012). Results suggest that an increase in OTT is associated with a decrease in quoted and effective spreads and an increase in depth for the sample of 60 stocks. When segmenting the stocks into market capitalization quartiles, stocks with lower market capitalization and liquidity exhibit a strong relation between OTT and spread based liquidity measures. Contrastingly, larger market capitalization firms exhibit a strong positive statistically significant relation with depth. Analysis of this relation with respect to quartiles sorted by message traffic, and trading activity reveals that stocks with lower message traffic exhibit a strong relation between improvements in spread based liquidity measures and OTT ratio, while stocks with a higher amount of message traffic exhibit a positive and statistically significant relation with OTT while stocks with a lower amount of message traffic exhibit a negative and statistically significant relation with OTT. Results for quartiles based on trading activity suggest that for stocks that have higher trading activity the relation between OTT ratio measure and spread based liquidity measures is weaker than for stocks that have lower trading activity, while for depth stocks with higher trading activity exhibit a stronger relation between depth and OTT. Further analysis reveals that the implementation of the IIROC 2012 Integrated Fee Model results in a statistically significant decline in message traffic, trading volume ($), OTT ratio measure, AT proxy, and liquidity measures. Panel data regression analysis reveals deterioration in

50

the relation between high OTT strategies, proxying for HFT, and market quality following the implementation of the IIROC 2012 Integrated Fee Model. This studys results have important implications for exchanges, market participants, and regulators. Results highlight the importance of message traffic, trading activity, and liquidity supplying HFT to liquidity supply and market quality on Chi-X Canada. High OTT trading strategies, and AT are associated with lower transaction costs (effective and quoted spread) and greater depth. The implementation of IIROCs 2012 Integrated Fee Model (1 April 2012) that determines a market regulation fee on a pro rata basis with respect to market participants message traffic and trading activity results in a decrease in message traffic and subsequently a corresponding deterioration in measures of market liquidity. This finding highlights the importance of message traffic, measured by the OTT ratio to market quality. By discouraging those liquidity providing HFTrs and ATrs, characterized as having high message traffic and trading activity, overall market liquidity declines.

REFERENCES Australian Securities and Investment Commission, 2012, Market supervision and competition cost recovery (1 January 2012 to 30 June 2013) new billing arrangements for ASX and Chi-X participants, http://www.asic.gov.au/asic/ASIC.NSF/byHeadline/Market-supervision-andcompetition-cost-recovery (accessed November 19, 2012) Bank of America, 2012, Update on the IIROC Market Regulation Fee Model for Canadian Markets.

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Brogaard, J., 2010, High frequency trading and its impact on market quality, Working Paper, Northwestern University. Brogaard, J., 2011, High Frequency Trading and Volatility, Working Paper, Northwestern University. Castura, J., Y. Dwivedi, R. Gorelick and R. Litzenberger, 2010, Market efficiency and microstruture evolution in U.S. equity markets: A highfrequency perspective, Working Paper, RGM Advisors, LLC. CESR, 2010a, Committee of European Securities Regulators, Call for Evidence. Microstructural issues of the European equity markets (April 1). http://www.cesr.eu/ data/document/10_142.pdf (accessed January 19, 2011). CESR, 2010b, Committee of European Securities Regulators, CESR Technical Advice to the European Commission in the Context of the MiFID Review and Responses to the European Commission Request for Additional Information (July 29). http://www.esma.europa.eu/index.php?page=document_details&from_title=Documents&id=7003 (accessed January 19, 2011). Chaboud, A., B. Chiquoine, E. Hjalmarsson and C. Vega, 2009, Rise of the machines: Algorithmic trading in the foreign exchange market, Board of Governors of the Federal Reserve System. Chi-X, 2012, Chi-X Canada, http://ca.chi-x.com/ (accessed November 19, 2012) Cvitanic, J., and A. Kirilenko, 2010, High frequency traders and asset prices. Working Paper. Domowitz, I., and H. Yegerman, 2005, The cost of algorithmic trading: A first look at comparative performance, In Brian R. Bruce (Ed), Algorithmic Trading: Precision, Control, Execution, Institutional Investor Inc, 30-40. Easley, David, Marcos M. Lopez de Prado, and Maureen O'Hara, 2011, The exchange of flow toxicity, The Journal of Trading 6, 8-13 European Parliament, 2010, Report on regulation of trading in financial instruments dark pools etc., Committee on Economic and Monetary Affairs, Rapporteur: Kay Swinburne. Hagstrmer, B., and L. Nordn, 2012, The Diversity of High Frequency Traders, Working Paper, Stockholm University School of Business.

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Hasbrouck, J., and G. Saar, 2010, Low Latency Trading, Working Paper, Cornell University. Hendershott, T., C. M. Jones and A. J Menkveld, 2011, Does Algorithmic Trading Improve Liquidity?, The Journal of Finance, 66, 1-33. Investment Industry Regulatory Organization of Canada (IIROC), 2012, Approval of Integrated Fee Model, February 3, 2012, 12-0043. Jovanovic, B., and A. J Menkveld, 2011, Middlemen in limit-order markets, Working Paper, New York University. Kirilenko, A., A. Kyle, M. Samadi and T. Tuzun, 2011, The flash crash: The impact of high frequency trading on an electronic market, Working Paper, University of Maryland. Menkveld, A. J., 2012, Does algorithmic trading improve liquidity? Working Paper, University of Amsterdam. Securities and Exchange Commission (SEC), 2010, Concept Release on Equity Market Structure. (Concept Release on Equity Market Structure), January 14, 2010. Tabb, L., R. Iati and A. Sussman, 2009, US equity high frequency trading: Strategies, sizing and market structure, TABB Group report.

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