Equities markets throughout the world have been undergoing fundamental structural upheaval in the past few years. As a result, regulators are now aiming to get their heads around several of the latest innovations in the Canadian trading landscape.

One of the biggest changes that has taken place in Canadian equities markets is the emergence of the multi-marketplace environment. The relatively simple days of an “upstairs market” for large institutional traders and a public stock exchange for the rest of investors are now distant memories. The Canadian trading business is still dominated by a traditional exchange, but it’s also now populated by more than a handful of alternative trading systems, a wide array of order types and increasingly sophisticated trading technology.

The regulators have, of course, permitted these developments to occur, but they are facing an ever-increasing challenge in keeping up with the innovations. With that in mind, the Canadian Securities Administrators and the Investment Industry Regulatory Organization of Canada have published a joint consultation paper concerning several of the major changes that have occurred in the Canadian market over the past couple of years — including the introduction of so-called “dark pools,” the use of “dark orders” and the impact of “smart” order routers, among other things.

There is no clear regulatory agenda to the paper; it sets out the concerns in a neutral fashion that some market players have with these new features, provides the counter-arguments and then presents a series of questions to solicit feedback on specific issues. The paper doesn’t deal with some of the other issues that have emerged along with the markets’ evolution, such as trading fees, data fees, locked and crossed markets, high-frequency trading, direct market access and proposed amendments to the ATS rules.

In short, the tension at the heart of many of the issues raised in the paper boils down to whether the anonymity provided by “dark” trading meaningfully impedes price discovery and compromises market fairness, as some argue; or, are these impacts more than offset by the added liquidity they attract, which thereby lowers transaction costs and improves market efficiency, as proponents suggest.

“The launch of certain new dark order types on transparent marketplaces has raised concerns about their potential impact on price discovery, the fairness of the interaction with visible orders, and liquidity,” the paper explains.

Conversely, defenders argue that these types of orders actually increase liquidity, boost order flow and can lead to better execution. “These benefits might offset any possible negative impact that dark order types have on the market,” the paper admits.

Concerns arise about fairness in the interaction between traditional, visible orders and the dark orders — that the visible orders take on risk when they help improve prices and that the hidden orders can take advantage of this contribution, positioning themselves for execution. Yet, the paper notes, some market players insist that “the fairness concern is minimized because visible orders are given time priority ahead of [hidden orders] at the same price on the same marketplace.”

Another practice that has caught regulators’ attention is the use of “indications of interest” by some dark pools in an effort to attract order flow by telling other trading systems and market players that there is an order for a particular security in the system.

The paper states that this raises a number of issues, including whether those placing the orders know that IOIs, revealing information about their trading intentions, are being used to drum up business. And at what point should an IOI be considered no different than an order (which then must comply with pre-trade transparency requirements under the existing ATS rules)?

The paper notes that releasing information about orders may create opportunities for “gaming,” as traders seek to gather more information about a supposedly hidden order: “This in turn can lead to the leakage of information, which can be used to exploit an order by traders positioning themselves ahead of the order.”

That info leakage, and the potential for gaming, the paper adds, reduces the benefits of dark pools, which are prized primarily for the anonymity they provide. As a result, some believe that the use of IOIs should be restricted or prohibited.

The counter-argument in favour of IOIs noted in the paper is that IOIs help attract liquidity: “Increased likelihood of information leakage and gaming can be offset by the ability to facilitate finding liquidity quickly and improving the execution obtained by the user, an ability which could become more important as the number of dark pools increase.”

@page_break@Another source of potentially troubling information leakage relates to the emergence of so-called “smart” order routers, which have been developed to help traders execute their orders in the multi-market environment by scanning all markets to discover the best price and/or to achieve best execution.

In general, the paper points out, these routers discover dark liquidity only incidentally; but the paper also notes that a marketplace that has introduced a smart router will include the hidden liquidity posted on that marketplace when making routing decisions.

Although the report factors in the fact that the hidden liquidity posted on a marketplace may improve executions and represent a competitive advantage, it indicates that some market players argue that having access to this information is unfair to other routers and traders who don’t have access to the same information; that it may lead to the execution against dark liquidity ahead of visible orders at the same price; and that there are questions about whether traders who are providing the hidden liquidity know that information about their intentions is being leaked in this way.

The paper doesn’t presume to provide any conclusions on these issues. It recognizes there are differing views regarding all of these various developments; thus, regulators are just seeking to solicit feedback and encourage discussion for now.

Given the significance and complexity of the subject matter, it is likely to be some time before this discussion leads to any regulatory changes — if any. The paper is out for comment until Dec. 29; the regulators have promised to hold an as yet unscheduled round table to discuss the results, suggesting that new regulations are not imminent. As well, some of these issues are under consideration by regulators in other jurisdictions, which may inform the policy debate in Canada.

Earlier this year, Mary Schapiro, chairwoman of the U.S. Securities and Exchange Commission, indicated that the SEC is also concerned about the role played by dark pools in the U.S. markets. In a speech, she suggested that the lack of post-trade transparency from dark pools in those markets has the potential to undermine market confidence.

This isn’t an issue in Canada, the CSA/IIROC paper explains, because the existing ATS rules require dark pools to report their trades to the information processor, which is, in turn, required to identify the source; so, it is possible to track how much activity is taking place in these venues.

However, the SEC is worried about an issue that does concern the Canadian markets — the use of IOIs. With the selective distribution of these quote-like messages, Schapiro has noted, “There is the danger that significant private markets may develop that exclude public investors.”

The CSA/IIROC report agrees, also concerned about the possibility that dark pools could impair price discovery — particularly if they attract significant order flow.

Indeed, much of the concern about dark pools undermining market integrity appears grounded in the notion that they could come to account for a significant share of market volume. But, so far, that doesn’t appear to be the case. Certainly not in Canada, in which only about 0.6% of the volume traded is in the existing dark pools, according to IIROC data for the 12 months ended June 30.

In the U.S., the dark pools’ market share is notably higher, but still not huge. A recent report from Goldman Sachs Group Inc. notes that dark pools still account for less than 10% of the volume there.

Moreover, the Goldman Sachs report argues that the introduction of dark pools has benefited, not disadvantaged, retail investors. The report points out that non-displayed liquidity has always existed, and maintains that dark pools represent “a technological evolution” of that traditional structure that has benefited all investors as the increased competition in the trading business has led to greater efficiencies, lower costs and better execution — gains that have trickled down to retail investors.

In Canada, the markets’ evolution is still at a comparatively early stage. Although ATSes (including dark pools) are capturing some market share from the traditional exchanges, that remains fairly small. The latest data from IIROC indicates that the Toronto Stock Exchange and TSX Venture Exchange still account for more than 94% of the volume traded over the 12 months ended June 30.

So far, predictions that ATSes would come to capture a large market share just haven’t materialized. Instead, it appears that they may be helping to boost trading volumes generally.

Recently, Toronto-based Black-mont Capital Inc. examined the market share being captured by the TSX’s biggest rival, the Alpha Trading System, which is primarily owned by the bank-owned dealers. The report found that the TSX is losing much less volume to Alpha than it assumed: “Based on our analysis, we believe electronic liquidity providers and other algorithmic traders are actually trading between Alpha and TSX, increasing the volumes for both. It would appear that much of the volume on Alpha may be just increasing the size of the pie rather than stealing a slice from TSX.”

One reason why the ATSes haven’t taken a bigger bite of the volume may be due to the fact that electronic equities trading remains a much smaller phenomenon in Canada than it is in the U.S. According to Greenwich Associates, electronic trading in Canada declined recently to about 17% of the total from around 20%; Greenwich cites “the breakdown in many algorithmic trading strategies during the crisis” as one reason for the drop.

Nevertheless, it predicts that this shift is likely to reverse itself in the years ahead, with more volume gravitating to electronic systems. IE