At its best, securities regulation can be hopelessly complex and fraught with unintended consequences that can harm the competitive landscape. The pitfalls are only magnified when a sector is in its infancy, which is why regulators face a big challenge as they try to ensure rules keep pace with an evolving trading business.

The Canadian Securities Administrators is considering some fundamental changes to the market structure rules; chiefly the implementation of trade-through protection requirements and a redefinition of “best execution” obligations. It is also proposing changes to the rules dealing with “direct market access” traders.

A trade-through entails traders not executing an order at the best available price, but taking an inferior price instead. They may be willing to do this for the sake of other considerations, such as speed, execution certainty or anonymity. Regulators are concerned, however, that certain orders, notably small retail ones, should be protected against trade-throughs to ensure market integrity, enhance investor confidence and preserve liquidity.

Best execution is related to the trade-through issue. It’s the obligation that dealers and advisors have to ensure their clients’ orders are treated well by their traders.

Earlier this year, the CSA and Market Regulation Services Inc. published a joint notice, setting out their views on the issues. The notice explains the regulators’ proposed approach, but it also indicates that the question of what sort of trade-through protection should be applied to the Canadian market isn’t completely settled as far as they are concerned.

Regulators held consultations on the subject almost two years ago, but failed to produce a consensus as to the proper response. They have since set out to craft a solution that aims to balance all the various players’ concerns.

Essentially, the notice proposes that some form of trade-through protection is required, but that marketplaces should have latitude to determine how to meet the obligations. It also proposes to expand the definition of best execution from a focus on price to encompass other relevant considerations, such as certainty, cost and speed.

The notice also asks a series of questions about the proposals, canvassing input on the devilish details that will be critically important to determining the regime’s market impact. The deadline for comments was late July, although a few of them trickled in past the deadline and into August. Yet it appears that there is still no consensus on many issues.

Certain aspects of the proposal, such as whether regulators should extend trade-through protection to foreign markets, are almost universally rejected. While there are a few supporters, most echo the comment of the Canadian Security Traders Association Inc. , which categorically rejects the notion of extending trade-through protection to orders entered on foreign markets, saying that Canada would probably be the only jurisdiction in the world to impose such an obligation.

Similarly, most commentators seem to agree that it will be tough to provide trade-through protection in a market with liquidity fragmented across multiple trading venues and without an information processor collecting and centralizing trading data.

In its comments, BMO Capital Markets wrote: “We believe the Canadian marketplace has evolved to the point at which it can support a centralized data consolidator and market integrator which would enhance effective delivery of best execution, trade-through protection and monitoring.”

Indeed, many commenters suggest that complying with trade-through protection requirements will be nearly impossible without someone doing the job of centralizing trade data.

So, while certain aspects of the proposals do have broad, if not unanimous, agreement, there still is no a compelling consensus about how to proceed. The basic problem is that the regulators are trying to craft rules for an environment that is still in its infancy. The established market has been around for some time, but there is also a growing list of upstart alternative trading systems that have only recently begun operating, or soon will begin operating. Each of the markets is trying to carve out its own niche in the trading universe. The markets’ efforts, in turn, are sparking competitive responses from the dominant market, TSX Group Inc. So, the competitive landscape is still in flux.

Moreover, the business is now very much technology driven. If someone can build a better trading mousetrap, then they can seize a competitive advantage.

It’s not like making new rules for the dealer business in which, while there may always be a supply of new entrants, no one is about to revolutionize the basics of the business. New dealers can open shop and compete, but they typically distinguish themselves with things such as branding and service.

@page_break@In the trading business, a firm can come up with better technology. For example, a system that enables firms to trade faster, smarter or more anonymously can grab a significant share of the business. There are typically substantial upfront development costs for such technology, in which competitive advances are now being measured in microseconds. Details of how the emerging venues must fit into the overall market can significantly affect development costs.

The potential for rules to create barriers to entry means that they can have a large impact on the competitive landscape. Onerous requirements can possibly tip the balance against innovation. At the same time, if there are genuine market failures or investor protection issues that require regulation, a regulator that doesn’t impose rules risks empowering a firm to compete largely on the basis of regulatory arbitrage.

Given the stakes, and the lack of an entrenched regulatory ideology, it’s not surprising that there remain divergent views over many of the details of the CSA’s proposals. Who should bear the obligations and how, when and ultimately where does the cost of compliance fall?

In fact, there isn’t even unanimous agreement that the regulators should carry out a cost/benefit analysis of their proposals. A CBA is usually a standard demand from the industry facing any regulatory initiative, let alone one as fundamental and far-reaching as market structure rules. Yet BMO suggests in its comment that a CBA on trade-through protection would itself be an unnecessary cost before the new electronic audit trail system is implemented.

Players that stand to benefit from increased competition in the trading game, not surprisingly, want regulators to move cautiously into the area. For example, the CPP Investment Board indicates in its comment that markets are still evolving, and will surely continue to evolve, so it’s important that the CSA tread lightly with an initiative — such as imposing trade-through protection — that may serve to limit inhibit innovation.

The Investment Industry Association of Canada also encourages caution, saying that the emergence of a multiple marketplace environment “presents a number of challenges” for both market players and regulators. “It is particularly important during this transitional phase to provide a flexible and adaptive regulatory environment and not entrench prescriptive regulation in light of such uncertainty,” it says.

Beyond such calls for caution, commentators also plead that further consultation is necessary in specific areas. The IIAC suggests, for example, that the idea of requiring dealers to interact with all available markets to ensure they are meeting their obligations, and limiting the fees that can be charged for access, needs further study.

“The creation of a system ensuring a captive market for new and unproven marketplaces presents many problems,” it cautions. The IACC adds that its consultations on that part of the proposal revealed that “this issue introduces certain complexities that affect the structure of the industry and require a more in-depth and specific consultation process.”

Rather than regulating the fees that markets can charge dealers for access, as the proposal contemplates, it recommends that dealers not be required to patronize a marketplace until it has demonstrated its relevance. “Given the costs associated with subscribing and connecting to a market, the determination of whether a market is relevant must go beyond its ability to display best price on a few specific securities,” it says. “This relevance approach rewards market performance rather than subsidizing unproven or underperforming markets by mandating dealer access.” It also requires, however, the development of a test for relevance, which the IIAC concedes would be no easy task.

More consultation is also proposed by Perimeter Markets Inc. , one of the early innovators in ATSes. It suggests that regulators form a working group of representatives from all existing and proposed marketplaces, and give it six months to come up with a model for a marketplace-level trade-through regime (MTTR).

It imagines that individual markets could then implement an MTTR tailored to its particular business, and that dealers and advisors would be able to rely on the markets to provide acceptable trade-through protection.

“This would provide an important benefit to all market participants and eliminate redundant replication of trade-through safeguards by dealers and institutions,” Perimeter says. It adds that the move would also allow dealers and advisors to easily satisfy the price portion of their best-execution obligations.

It remains to be seen whether regulators latch on to any of the ideas. It’s encouraging to see the industry trying to help regulators navigate such thorny and mercurial ground, but it will be some time before we can know how well they have done. IE