Regulators are warning brokerage firms seeking heftier profits by sending their retail order flow south of the border that these arrangements may not comply with Canadian trading rules, and that they may have to stop.
The Canadian Securities Administrators (CSA) issued a notice Monday detailing their concerns with Canadian brokers routing retail equity orders to U.S. dealers in order to take advantage of the U.S. market structure, which allows payment for order flow, and charges lower trading fees. And, at the same time, the Investment Industry Regulatory Organization of Canada (IIROC) published new guidance reminding firms that orders that are executed on foreign markets must comply with Canadian trading rules in this area.
Concerns about Canadian brokers routing their retail orders through the U.S. in order to take advantage of the more favourable trading economics arose recently when the TMX Group Inc. proposed a series of changes to its trading models that aim, in part, to stem the flow of Canadian retail liquidity to the U.S. While the TMX is worried about that trend from a revenue perspective, the regulators indicated today that they also have concerns about the possible impact on market quality in Canada, and that investor protection may be undermined by the practice.
Migrating trades: Southward ho?
In its notice, the CSA says that it is worried about Canadian investors have their trades executed in U.S. dark pools which don’t impose the same sort of minimum price improvement requirements that trades conducted in Canadian dark pools must provide. “These retail orders are being executed by U.S. dealers without consistently meeting the minimum price improvement requirement set out in the dark liquidity regime implemented in 2012,” the CSA says.
Beyond that specific worry, the CSA stresses that it has “public interest concerns” regarding the practice of dealers routing to U.S. dark pools. “Specifically, the CSA are concerned that widespread routing of retail order flow to U.S. dealers will negatively impact the quality of the Canadian market, and may affect the quality of execution achieved for investors,” it says.
“Retail orders are an important part of the Canadian market ecosystem, and the CSA continue to support the existing rule framework, which emphasizes the importance of these orders to the quality of the Canadian equity market, including the price discovery process,” the CSA adds.
IIROC issues Foreign Organized Regulated Market guidance
IIROC also issued guidance Monday that reminds firms they can route trades outside of Canada if these trades are executed on a “foreign organized regulated market” (FORM), as defined in the Canadian trading rules. And, it stresses that U.S. brokers don’t meet that definition. “Dealer registration is not equivalent to market registration,” IIROC says in its guidance; adding that U.S. broker-dealers that “internalize” orders by matching them with their own inventory do not meet the definition of a FORM.
The guidance notes that certain firms “may have established order routing practices that do not take into account IIROC’s criteria” for qualifying as a FORM; indicating that firms “may need to change their practices in order to comply” with the trading rules.
IIROC says that the definition of a FORM was implemented with the objective that trades conducted outside of Canada should be on a market that has “substantially the same regulatory monitoring and dissemination of data to the public as would be present if the trade had been conducted on a marketplace in Canada.” It notes that “simple trade reporting facilities” are not recognized as marketplaces in Canada. “IIROC’s views have not changed in this regard, and the originally stated objective continues to be the policy objective underlying the FORM definition,” it says.
The CSA indicates that it is supportive of IIROC’s new guidance, and that it is working with the self-regulatory organization to “evaluate and develop appropriate regulatory measures to ensure the continued quality of the Canadian equity market.”