Canada’s equity market has a history of respecting the role played by retail clients in the price discovery process. Although rules have been in place for some time that aim to preserve liquidity on Canadian equity exchanges, the creation of dark pools and dark order functionality has chipped away at the protection provided by these rules. Recent proposals address gaps in the rules that have allowed order flow to migrate away from lit marketplaces. This article can serve as a guide to those in other jurisdictions who wage the battle against internalization. For this purpose, the following information is provided:
- overview of the current Canadian market integrity rules that support exchange liquidity;
- history of the development of these rules;
- recent market structure changes that have favored dark pools and internalization models; and
- current Canadian regulatory proposals to address imbalances.
In Canada, the Investment Industry Regulatory Organization of Canada (IIROC) oversees all trading activity on debt and equity marketplaces. Operating under recognition orders from the Canadian Securities Administrators (CSA), IIROC sets, monitors compliance with, and enforces market integrity rules that govern trading activity on these Canadian marketplaces. These rules are known as the Universal Market Integrity Rules (UMIR).
UMIR 6.3 is the order exposure rule.This rule requires participants to immediately enter on a lit marketplace a client order that is 50 standard trading units (generally 5000 shares) or less. There are limited exceptions to this rule, one of which permits internalization with price improvement by the participant. That is, if a participant executes the order upon receipt at a better price, then the participant is not required to send the order to a lit marketplace.
A related rule is UMIR 8.1, the Client-Principal Trading Rule. Under this rule, a participant that receives a client order for 50 standard trading units or less of a security with a value of $100,000 or less may execute the client order against a principal order or non-client order at a better price provided the participant has taken reasonable steps to ensure that the price is the best available price for the client under prevailing market conditions.
The late 1990’s held significant change for the Canadian equity market, including the development by Canadian securities regulators of a framework to encourage ATSs to enter the Canadian market.To address fragmentation of the Canadian equity market, the Toronto Stock Exchange (TSX) Board of Governors in 1996 established a Special Committee to suggest reforms that could improve TSX’s market quality in the face of such fragmentation. The Special Committee’s report (Report), Market Fragmentation: Responding to the Challenge, was published in 1996. The Report states that in order for TSX to continue to be the foundation for a competitive Canadian equity market, the price discovery resulting from the exchange’s auction process must be as efficient as possible. In the Report, the Special Committee expressed a concern that the practice by members of withholding small orders that could otherwise be filled in the public market (referred to by the Special Committee as “internal” fragmentation) directly affects the liquidity that the public markets can provide. The Report did acknowledge that not all internalization activities were necessarily detrimental to the market, and that institutional clients with large orders would not want their orders exposed if such disclosure would cause the market to move away from them.
In response to recommendations made in the Report, new rules were proposed by TSX in 1997 to address the threat raised by “internal” fragmentation – or internalization. TSX’s rules were the precursor to UMIR. The TSX market integrity rules became UMIR when they migrated to IIROC’s predecessor organization upon its launch in 2002.
The 1997 TSX rule proposals, which came into force in 1998, were created with the intent of minimizing the opportunities for internalization of small client orders. The impact of this rule change was expected to result in a greater number of orders being sent to the TSX central order book, thereby creating a more liquid, deeper market. As stated in the members notice that requested comment on this rule proposal, “the price discovery process must remain viable.”Thus, the original order exposure rule became effective in 1998 with the same significant exceptions that exist today in UMIR 6.3 (that is, client instructions can override the requirement to immediately expose the order, and internalization can occur at the member firm so long as a better price is achieved for the client). One difference is that the original threshold was set at 1200 shares (lower than the current 5000 share threshold). The threshold of 1200 shares was selected because in 1997 that was the size of the average retail order on TSX for a stock trading over $5.
We’ve got rules – So what’s the problem?
The rules that had protected the visible book in Canada did not foresee dark trading functionality that would permit executions at fractional prices. This was not a concern in the rules’ first ten years, but with the arrival in Canada in July 2007 of dark pools that were permitted to execute with fractional price improvement, small orders that were previously either exposed to the market or given full tick price improvement by participants, began to be sent to dark pools. This occurred despite the requirement in UMIR 6.1 that orders must be entered on a marketplace in whole cents.
With the introduction of dark pools then came an unintended consequence of UMIR 6.3. In achieving a “better price” for its retail clients, a participant could now have the order executed outside of the displayed market, but with only fractional price improvement being provided at the dark pool. This price improvement has been as little as 10% of the National Best Bid and Offer (NBBO) spread, or one-tenth of one cent.
Highlighting this issue as one for public debate took some time in Canada because the regulatory framework of National Instrument 21-101 Marketplace Operation (NI 21-101) does not require the same level of public disclosure for ATSs as it does for exchanges. Thus, while exchange order types and exchange allocation methodology is set out in trading rules that must be published for a public comment period prior to regulatory approval, such disclosure is not required to be made by ATSs.TSX was able to learn about the undisclosed allocation methodologies of dark pools only by gathering market intelligence. Advocacy with the Canadian securities regulators did however ultimately lead to the commencement of a public process to discuss market structure issues with a focus on dark trading.
In 2009, the CSA published a joint consultation paper with IIROC to seek comment on a number of issues including the impact of dark pools on the Canadian market.A forum on dark liquidity was then held in March 2010.
The Canadian regulators have taken into account views voiced in the Canadian dark liquidity debate as well as factors discussed at international organizations such as IOSCO in formulating their 2010 position paper (Position Paper).The Position Paper recommends, among other things, that the only exemption to pre-trade transparency should be for orders that meet a minimum size threshold, and that meaningful price improvement means that the price is improved over the NBBO by a minimum of one trading increment except where the NBBO spread is already at the minimum trading increment in which case meaningful price improvement would be at the mid-point of the spread.
In response to the recommendations in the Position Paper, IIROC has proposed amendments to UMIR.To address the regulatory arbitrage opportunities created by the arrival of dark pools, the proposed amendments revise the definition of “better price” to be improvement of at least one trading increment unless the spread is one trading increment in which case “better price” is improvement by one-half of one trading increment. IIROC has also proposed adding a new section (UMIR 6.6) that provides that an order may only execute against a dark order if the order is executed at a “better price”. There is an exception that large orders (more than 50 standard trading units (generally, 5000 shares) or with a value of more than $100,000) can execute with a dark order at the NBBO.
Significant commentary was made and a large number of submissions were received in response to the IIROC proposal. With the comment period closed but no final rule as of the date of writing this article, it is yet to be seen whether IIROC will move forward with its proposal. TMX Group strongly supports IIROC’s proposal. As stated in the TMX Group comment letter, “we believe that the Amendments will result in regulation that supports price formation on lit marketplaces, which is a result that will benefit all market participants”.
The road ahead and lessons learned
The Canadian experience with dark liquidity in equity markets is an example of how policy is best developed in an open, transparent process. Canadian dark pools came to market without benefit of any public comment and were permitted to operate without publicly available rule sets. The de facto policy shift that occurred as these dark pools received regulatory approval was therefore not publicly debated nor was the impact of the dark pools’ operations on market structure generally understood. These internalization vehicles were therefore permitted to grow without appropriate rules being set to ensure that the highest quality of price discovery on Canadian lit marketplaces would continue.
In hindsight, greater vigilance was required by all stakeholders to ensure that the introduction of new players, in the form of dark pools, did not have unintended consequences on the market as a whole. With the approval of these new entrants, policy was being created on a case-by-case basis without regard to long-standing rules that worked to protect the market as a whole. With the more recent benefit of public debates and transparent proposals on dark liquidity, the Canadian market can proceed with creating policy that can continue to protect our visible exchanges and enhance the benefits that these lit marketplaces provide to all stakeholders.
Deanna Dobrowsky is the Director, Regulatory Affairs at TMX Group. TMX Group's key subsidiaries operate cash and derivative markets for multiple asset classes including equities, fixed income and energy. Toronto Stock Exchange, TSX Venture Exchange, Montréal Exchange and other TMX Group companies provide listing markets, trading markets, clearing facilities, data products and other services to the global financial community.